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ACA FM > Hedging > Flashcards

Hedging Flashcards

1
Q

FX Future - Set up Hedge

A
  1. If $ receipt -> want to sell $ so buy £ future
  2. Choose Maturity date -> close to receipt date but not before
  3. No of contracts = ($ receipt/payment / Futures Rate) / £62,500
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2
Q

FX Future - Outcome of Hedge

A

Gain/loss = (Sell rate - Buy rate) x No of contracts x £62,500
Convert at spot rate with receipt/payment

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3
Q

FX Future - Advantages

A
  • Hedge downside risk
  • Can close out position at any time
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4
Q

FX Future - Disadvantages

A
  • Loses upside potential
  • Standardised contracts so can over/under hedge
  • Basis risk
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5
Q

Money Market Hedge - $ Payment

A

Deposit $ - earn interest
Convert at spot
Borrow in £
Pay loan - pay interest

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6
Q

Money Market Hedge - $ Receipt

A

Borrow $ - pay interest
Convert at spot
Deposit in £
Take deposit - earn interest

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7
Q

Money Market Hedge - Advantages

A
  • Hedges downside risk
  • Tailored to investment - wont over/under hedge
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8
Q

Money Market Hedge - Disadvantages

A
  • Loses any upside potential
  • Difficult to unwind
  • Unlikely cheaper and greater admin
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9
Q

Traded Currency Option - Set up Hedge

A
  1. If $ receipt we want to sell $ and buy £ so buy call option
  2. Choose strike price and maturity date
  3. No of contracts = ($ receipt/ strike price)/£31,250
  4. Pay premium $ = no of contracts * prem(cent)/100 x £31,250
  5. Convert premium at spot
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10
Q

Traded Currency Option - Outcome of Hedge

A

Gain on option = (Spot-Strike) x no of contracts x £31,250
Convert at spot rate
If dollar strengthens let option lapse

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11
Q

Traded Currency Option - Advantages

A
  • Protects from downside risk
  • Benefit from upside potential as can let it lapse
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12
Q

Traded Currency Option - Disadvantages

A
  • Premium can be expensive
  • May over/under hedge
  • Not available in all currencies
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13
Q

OTC Currency Options - Set up the Hedge

A
  1. If $ receipt we will want to sell $ so have to buy a put option
  2. Choose strike price
  3. Pay premium £ upfront
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14
Q

OTC Currency Options - Outcome of Hedge

A

If dollar weakens than exercise option and covert at strike

If dollar strengthens then let option lapse and convert at spot

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15
Q

OTC Currency Options - Advantages

A
  • Protects from downside risk
  • Benefits from upside potential
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16
Q

OTC Currency Options - Disadvantages

A
  • Premium can be expensive and needs to be paid upfront
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17
Q

Index Future - Set up the Hedge

A
  1. Sell index futures
  2. Choose futures date (based on when want to hedge)
  3. Note futures price
  4. No of future contracts = Share portfolio value / (futures level x £10)
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18
Q

Index Future - Outcome of Hedge

A

Gain/loss on futures = (Futures at start - current futures) x no of contracts x £10
Calculate gain/loss on portfolio

19
Q

Index Future - Advantages

A
  • Hedges downside risk
  • Can close out futures at any time
20
Q

Index Future - Disadvantages

A
  • Standardised contracts - can over/under hedge
  • Removes any upside potential
  • Basis risk
21
Q

Share Index Options - Set up Hedge

A
  1. Buy put index options
  2. Choose strike price and maturity date
  3. Calculate number of contracts = Share portfolio value / (strike price x £10)
  4. Pay premium = points x £10 x no of contracts
22
Q

Share Index Options - Outcome of Hedge

A

Gain on option = (Strike level - current spot index level) x no of contracts x £10
Calculate gain/loss on portfolio
Deduct premium

23
Q

Share Index Options - Advantages

A
  • Protects from downside risk and allows benefit from upside
24
Q

Share Index Options - Disadvantages

A
  • Standardised contracts - may over/under hedge
  • Premium can be expensive
25
Q

Interest Forward Rate Agreements - Set up Hedge

A

Decide FRA term - e.g 3-6 FRA means starts in 3 months lasts 3 months
Buy FRA (if borrowing in future)

26
Q

Interest Forward Rate Agreements - Outcome of Hedge

A

Net settlement on the FRA = (Spot rate - FRA rate) x nominal value x time/12
Borrow money from bank at spot rate

27
Q

Interest Forward Rate Agreements - Advantages

A
  • Hedges away downside risk
  • Tailored to investment
28
Q

Interest Forward Rate Agreements - Disadvantages

A
  • Usually only available on loans > £500k
  • Usually < 1 year
  • Removes upside potential
  • Difficult to exit
29
Q

Interest Rate Futures - Set up Hedge

A
  1. Futures rate = 100-r (where r = fixed interest rate)
  2. Sell futures (if borrowing)
  3. Choose Maturity date
  4. No of contracts = (Borrowing value / £500k) x (Borrowing period / 3)
30
Q

Interest Rate Futures - Outcome of Hedge

A

Gain/loss on futures = ((Sell price - Buy price)/100) x no of contracts x £500k x 3/12

Borrow money from bank at spot rate

31
Q

Interest Rate Futures - Advantages

A
  • Hedges away from downside risk
  • Can close out position at any time
32
Q

Interest Rate Futures - Disadvantages

A
  • Removes any upside potential
  • Standardised contracts - may over/under hedge
  • Basis risk
33
Q

Interest Rate Options - Set up Hedge

A
  1. Buy put option (if borrowing)
  2. Choose strike price
  3. Choose maturity date
  4. No of contracts = (borrowing value/£500k) x (borrowing period / 3)
  5. Pay premium = no of contracts x £500k x premium % x 3/12
34
Q

Interest Rate Options - Outcome of Hedge

A

If exercise option:
Sell futures at strike
gain on future = ((sell price - buy price)/100) x no of contract x £500k x 3/12
Borrow money at spot rate

35
Q

Interest Rate Options - Advantages

A
  • Protects from downside risk
  • Benefit from upside
36
Q

Interest Rate Options - Disadvantages

A
  • Premium can be expensive
  • May over/under hedge
  • Basis risk
37
Q

Interest Rate Swaps - Advantages

A
  • Can either provide fixed or floating interest
  • Can be longer term than FRAs/ futures / options
  • Can be used to achieve lower borrowing costs
38
Q

Interest Rate Swaps - Disadvantages

A
  • If swap for fixed interest you lose upside of variable
  • If swap for variable than risk them raising
  • Risk that counterparty defaults
  • The swap can make the accounts look misleading
39
Q

Interest Rate Parity (IRP)

A

Uses nominal interest rates from two countries and spot exchange rate to:

Determine a fair forward exchange rate

Predict the future expected spot rate

40
Q

IRP formula

A

Spot rate x ((1+ if)/ (1+iuk)) = forward rate

If = overseas nominal interest
Iuk = uk nominal interest

41
Q

Purchasing Power Parity (PPP)

A

That a basket of goods in one country will cost the same no matter where it is traded

42
Q

PPP Formula

A

Spot rate x ((1 + hf) / (1 + huk)) = expected future spot rate

Hf = overseas inflation rate
Huk = Uk inflation rate

43
Q

PPP Formula

A

Spot rate x ((1 + hf) / (1 + huk)) = expected future spot rate

Hf = overseas inflation rate
Huk = Uk inflation rate

ACA FM (8 decks)

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