Hedging Flashcards
Forward (interest rates)
A binding obligation to buy or sell something at a point in the future but at a fixed price today. Avoids downside risk, but no possibility of upside potential.
Future (interest rates)
A contract whose value varies with an underlying product. This is a standardised product.
Negotiated option
The right but not the obligation to buy or sell something at a point in the future at a price fixed today. No downside risk but still retains upside potential.
Traded option
The right but not the obligation to buy (call) or sell (put) a futures contract. A premium is payable regardless of whether the option is exercised.
FRA’s
A borrower will buy a FRA and a lender will sell a FRA
Borrowing (futures)
Sell future contracts
Depositing (futures)
Buy futures contracts
Borrowing (options)
Buy Put options
Depositing (options)
Buy Call options
What to do with interest rate swaps
1) Borrow at the unpreferred favourable rate. 2) Swap payments with a counterparty who wants variable but has borrowed at a fixed rate. 3) The amount of the payments ensures that the benefit of the reduced interest rates is split between the two parties.
Share options - Call option
the option to buy the shares later
Share options - Put option
The option to sell shares later
Share options - In the money
Exercising today would give a profit
Share options - Out of the money
Exercising today would give a loss
Share options - Intrinsic value
The profit that would arise by exercising today.
Share options - Time value
Calculated by taking the intrinsic values from the option premium..
Transaction risk
Where a transaction is to be settled in a foreign currency, the risk that the exchange rate will change between the date of contract and the date of settlement of the fund.
Economic risk
The risk that the values of the business will be affected by long run changes in exchange rates
Translation risk
The risk that reported performance will be affected by exchange rate movements.
Currency hedging - Futures and traded options
If it is a purchase need to sell futures today or BUY PUT options. If it is a receipt need to BUY futures today and BUY call options
Interest rate parity theory
Exchange rates move to compensate for differences in interest rates.
Purchasing Power Parity Theory
Exchange rates move to compensate for differences in inflation rates.
