Topic 15: Hedging Flashcards
What is the definition of hedging?
Eliminating or reducing variability of the d.c. value of a f.c. position by taking compensating action/transactions on the other side to secure against loss.
Should we hedge everything? Why?
- Nope, Hedging has it’s own costs.
- Reduces profit to upside risks.
- Costs time and premiums
- Extra money might be better spent on forecasting then hedging.
When a firm has a payable, when will it hedge in the forward market?
Assuming it is risk adverse, then:
When S1e >= F1 -> Hedge as forward rate is definitly better then your expectations.
When S1e < F1 -> not clear, depends on risk adversity / exact difference.
How does money market hedging work?
- You convert money immediatly, and let it earn interest in a foriegn asset, then pay the amount when it is due. Knowing the periods & interest rates, you convert the right amount to pay it exactly.
- Also called a synthetic forward.
Fill in this table for synthetic hedges.
Say you have to pay some known f.c. amount at t = 1.
How could you hedge this risk in the money market?
t = 0:
- Borrow S0P* / (1+i*) at i
- Convert to f.c, ending with P* / (1 + i*)
- Invest at i*
t=1:
- Receive (1+i*)P/(1+i*) = P*.
- Pay P*.
- Pay S0P*(1+i)/(1+i*) (amount borrowed domestically).
Show how to construct a synthetic hedge for a recievable.
t = 0:
- Borrow R* / (1+i*) at i*
- Convert to d.c., ending with R*S0 / (1+i*)
- Invest at (1+i)
t=1:
- Receive R*.
- Pay R* (1 + i*) / (1+i*) = R*.
- Collect final profit of S0(1+i)/(1+i*) per R*.
What is the payoff of a put option (for a recievable).
What about for a call option (for a payable).
Payoff for Put = d.c. of receipts if hedged - d.c. reciepts if not hedged.
Payoff for Call = d.c. payable if not hedged - d.c. of payable if hedged.
Does money market hedging differ in costs / results to forward hedging.
Note when CIP holds, as the hedge costs S0(1+i)/(1+i*), which is equal to F0 under CIP.
Use a diagram to illustrate the result of hedging a recievable with an option vs not hedging.
Use a diagram to illustrate the result of hedging a payable with an option vs not hedging.
Where R = recieveable in d.c.
R* = recievable in f.c.
r = premium for option in d.c. terms. (i.e. d.c. paid as premium per f.c. of recievable.)
Purchase a call option on f.c.
Diagram correction: SxP*+rP*, not SxP*.
Show the profit / loss from a recievable hedge with a graph. Explain what the lines mean.
The profit / loss to movement lines show the profit and loss to the option / hedge as the exchange rate moves compared to if it remained at the strike price and no hedging was conducted.
The zagged line shows the profit from choosing the hedge over not hedging, at different spot rates for the second period.
Use a graph to illustrate profit / loss to hedging with or without an option for a payable.
Explain the lines.
The profit / loss to movement lines show the profit and loss to the option / hedge as the exchange rate moves compared to if it remained at the strike price and no hedging was conducted.
The zagged line shows the profit from choosing the hedge over not hedging, at different spot rates for the second period.
What is contingent hedging?
When there are two layers of hedgings, because one action is contingent on another.
Give an example that would require contingent hedging. What is the best way to hedge?
- Trying to win contract. If you win, you will recieve
- Lump sum payment of f.c. in future period.
Could buy a put option for f.c.
But if the put option is too expensive to be worth it, alternative is to wait until the contract is awared then purchase a forward if necessary.
