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Foreign Exchange Exposure Cash flows of firm, ergo its market value, are affected by changes in the value of foreign currency, FX. Transactions Exposure.

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Presentation on theme: "Foreign Exchange Exposure Cash flows of firm, ergo its market value, are affected by changes in the value of foreign currency, FX. Transactions Exposure."— Presentation transcript:

1 Foreign Exchange Exposure Cash flows of firm, ergo its market value, are affected by changes in the value of foreign currency, FX. Transactions Exposure – Explicit contractual amount denominated in FX. Operating Exposure – No contract exists yet FX exposure is present.

2 Two Methods of FX Quotation Direct Quotation Number of home (domestic, reference) currency units per unit of FX. Direct quote is inverse of indirect quote. Assumed in this course (intuitive). Indirect Quotation Number of FX units per unit of home (domestic, reference) currency. Indirect quote is inverse of direct quote. Not employed in this course (less intuitive).

3 Examples of Two Quotation Methods For Canadian firm. Direct quote on greenback, US$: C$1.053 Indirect quote on greenback US$: US$0.95 If FX appreciates (rises in value), the direct quote rises and the indirect quote falls. If FX depreciates (drops in value), the direct quote drops and the indirect quote rises.

4 Transactions Exposure First part of this four part course. Exporter - receives a contractually set amount of FX in future. Importer – pays a contractually set amount of FX in the future. Measure of FX exposure – the amount of FX involved.

5 Exporter’s Transactions Exposure Canadian beef exporter will receive US$1 million 3 months from now. S = direct quote on the greenback, i.e. C$/US$, 3 months hence. (Note: / means per.) S is plotted on horizontal axis. Exposed cash flow (ECF) = S x US$ 1 million. ECF is plotted on vertical axis.

6 Exporter’s Risk Profile S(C$/US) ECF(C$) US$1million

7 Exporter’s Risk Exposure Worried about depreciation in FX. Forward hedge: Sell FX forward. Arrange now to sell 3 months hence at price determined now, F (the forward rate). Option hedge: Buy right to sell FX, a put option on the FX.

8 Sell Forward Hedge Commit now to sell U$ 1 million 3 months from now at forward price, F, determined now. Price paid for Forward Contract = zero. Sell forward contract cash flow = (F – S) x U$ 1 million where S is the spot rate 3 months hence.

9 Sell Forward Contract S(C$/U$) Contract Cash Flow F(C$/U$)

10 Hedge with Forward Contract S(C$/U$) F x U$1million Hedged Cash Flow

11 Hedge with Put Option Put option is the right, not obligation like forward contract, to sell U$ 1 million 3 months hence at an exercise or strike price of X(C$/U$). P, put premium, price paid now for option. Put contract cash flow = X – S if S { "@context": "http://schema.org", "@type": "ImageObject", "contentUrl": "http://images.slideplayer.com/13/4165957/slides/slide_11.jpg", "name": "Hedge with Put Option Put option is the right, not obligation like forward contract, to sell U$ 1 million 3 months hence at an exercise or strike price of X(C$/U$).", "description": "P, put premium, price paid now for option. Put contract cash flow = X – S if S

12 Put Contract Cash Flow S X

13 Hedge with Put Option S X Hedged Cash Flow

14 Which is better? Sell forward or Buy put? S B B = breakeven point SB, buy put better

15 Determination of B, breakeven FX Rate B is point of indifference between sell forward and buy put as hedges. SB Put is better ex-post B = Forward rate + Future Value of Put Premium; where interest rate is hedger’s borrowing rate. B = F + FV(P).

16 Hedging a U$ Receivable Canadian firm with U$ receivable due 6 months hence F (6 month forward rate) = C$ 1.35 X (exercise price) = C$1.32 P (put premium per U$) = C$0.05 Borrowing rate = 6% quoted APR B (breakeven) = C$1.4015

17 3 Different Interest Rate Quotes Borrow $1 for 6 months at 6%: APR, annual percentage rate, FV = $1.03 = $1 (1 +.06/2 ) EAR, effective annual rate, FV = $1.02956 = $1 (1 +.06)^.5 CC, continuously compounded, FV = $1.03045 = $1 exp(.06 x.5) Default assumption: All interest (inflation, appreciation) rates are annual.

18 Canadian Importer Problem Has U$ 5 M payable due 6 months hence. Two possible hedges: buy U$ forward or buy call on U$. Buy forward: Arrange now to buy U$5M 6 months from now at a rate set now, F. Buy call on U$ 5 M with exercise price X.

19 FX Payable Worried about the FX appreciating S -U$ 5 M Exposed Cash Flow

20 Buy U$ Forward: Contract Cash Flow F U$5M S

21 Buy Call on U$: Contract Cash Flow X S U$5M

22 Hedged Cash Flows S Forward Hedge -F x U$5M B Call Hedge X

23 Buy forward versus buy call B S Contract Cash Flows

24 B, breakeven FX rate between call and buy forward hedges B = forward rate - FV of call option premium FV (future value) uses the hedger’s borrowing rate. SB buy forward better ex-post.

25 Calculation of B Canadian firm with U$ 5 M payable due 6 months hence. F = C$1.35 ( 6 month forward rate) X = C$1.32 (exercise price of call) C = C$0.10 (call premium per U$) Borrowing rate = 6% quoted CC B = C$1.247

26 Significance of B = C$1.247 If futureS > 1.247 better to buy forward ex-post. If futureS < 1.247 better to buy call ex-post. Define Pr( ) = probability of the event ( ). If Pr(futureS>1.247) > Pr(futureS<1.247), better to buy forward, rather than buy call, ex-ante. Principle: The better ex-ante hedge is that which maximizes the probability of choosing the correct hedge ex-post.

27 Forward vs. Option Hedges: Fundamental Trade-off Forward – no up-front outlay (at inception value of forward = 0) but potential opportunity cost later. Option – up-front outlay (option premium) but no opportunity cost later, ignoring option premium.

28 Option hedge vs. Forward hedge vs. Remain exposed Hedge FX liability. Ex-post analysis: S > F, buy forward is best; S < F, remain exposed is best. Option hedge is never best ex-post. Option hedge is an intermediate tactic, between extremes of buy forward and remain exposed.

29 Option hedge vs. Forward hedge vs. Remain exposed F Remain exposed

30 Writing options as hedges Zero sum game between buyer and writer. Writer’s diagram is mirror image of buyer’s about X-axis. Writer receives premium income. Write call to hedge a receivable, I.e., covered call writing. Write put to hedge a payable.

31 Basic problem with writing options as a hedge Viable if there is no significant adverse move in FX rate. FX receivable: viable if FX rate does not drop significantly. FX payable: viable is FX rate does not rise significantly. The original exposure remains albeit cushioned by the receipt of premium income.

32 A Lego set for FX hedging Six basic building blocks available for more complex hedges. Buy or sell forward. Buy or write a call. Buy or write a put.

33 Application of Lego set Option collar is an option portfolio comprised of long (short) call and short (long) put. Maturities are common but exercise prices may differ. What if there is a common exercise price = F, the forward rate pertaining to the common maturity of the options? Value of option collar must = zero. Option collar replicates forward contract.

34 Option collar (buy call, sell put; common X = F) or Buy Forward F S

35 F defines a critical value of X Another application of Lego set, option collars, and graphical reasoning. If X = F, C (call premium) = P (put premium). If X P. If X> F, C < P.

36 Salomon’s Range Forward Another application of Lego set. See Transactions Exposure Cases: Salomon Contract to Aid in Hedging Currency Exposure. Buying a Range Forward is an option collar where a call, with X = upper limit of range, is purchased and a put, with X = lower limit of range, is written.

37 Salomon’s Range Forward (specific numbers) F = 1/DM 2.58 = U$0.3876 Range Upper limit, U= 1/DM2.50 = U$0.40 Range Lower limit, L = 1/DM2.65 = U$0.3774 If S(U$/DM) > U$0.40, US client buys DM at U$0.40. If S < U$0.3774, US client buys DM at U$0.3774. If U$0.3774 < S { "@context": "http://schema.org", "@type": "ImageObject", "contentUrl": "http://images.slideplayer.com/13/4165957/slides/slide_37.jpg", "name": "Salomon’s Range Forward (specific numbers) F = 1/DM 2.58 = U$0.3876 Range Upper limit, U= 1/DM2.50 = U$0.40 Range Lower limit, L = 1/DM2.65 = U$0.3774 If S(U$/DM) > U$0.40, US client buys DM at U$0.40.", "description": "If S < U$0.3774, US client buys DM at U$0.3774. If U$0.3774 < S

38 Salomon’s Range Forward S U=$0.4 L=$0.3774 Contract Cash Flow

39 Salomon’s Range Forward S LU FX Liability Hedged Cash Flow

40 2 alternative ways of committing to buy (sell) FX in future Futures Contract Traded anonymously on an exchange. “Marking to market” – there are daily cash flow experienced. Assume: futures rate = forward rate. Forward Contract Deal directly with bank. No cash flows until maturity Empirical result: For FX, futures rate = forward rate on average.

41 Conditional (contingent) exposure Whether or not you are exposed to the contractually specified FX depends on someone else’s decision. Situation where an option should be used, not a forward. Examples: cross-border merger, bidding on a foreign construction contract, selling with a dual currency price list.

42 Telus Case Dual currency prices: C$1,682 or Bh32,799. Customer decides on currency. Hedging the time span between sale and customer’s currency decision must be with a put option, not sell forward. Defined implied spot rate, S* = C$0.051= C$1,682/Bh32,799.

43 Telus’ Risk Exposure C$0.051 S(C$/Bh) C$1,682

44 Effect of dual currency prices Client chooses to pay currency adjusted amount. As if the following were true: Telus demands payment in C$’s but gives client a put option on Bh. Since Telus issues a put option to the client, it must buy the same option to hedge.

45 Danger in hedging conditional exposure with a forward Problem if Telus were to sell Bh forward: Telus may not receive Bh’s. Client will choose to pay in C$’s if the Bh appreciates beyond C$0.051. If Bh appreciates, Telus must satisfy the forward contract by buying the appreciated Bh on the spot market.

46 Telus’ hedged diagram if sell forward at F = C$0.051 C$0.051 C$1,682 Telus faces unlimited losses

47 Linkage between forward and options Forward contract is an option collar. Buy forward = buy call, sell put with X = F. Sell forward = sell call, buy put with X = F. Value of option collar = 0. What if X not = F? Put-Call-Forward Parity Theorem

48 Put Call Forward Parity (graph) XF S

49 Put Call Forward Parity C, P = Call and Put premiums R = domestic risk-free rate

50 Put-Call Forward Parity Example 1-year contracts on sterling, PS. F = C$2.50; X = C$2.40; T = 1 year R (riskless Canadian rate) 5% quoted CC Via equation, C-P = C$0.095 If P = C$0.05 then C = C$0.145. If C = C$0.20 then P = C$0.105.

51 Value of buy forward contract post inception F’s are forward rates, N – new versus O – original. R is domestic risk-free rate, T remaining maturity of forward at new date. Another interpretation: F N is prevailing forward rate; F o is desired contractual rate.

52 Value of buy forward post inception FO FN

53 Post inception buy forward example Bought 13-month sterling forward a month ago at then prevailing forward rate, F 13 = C$2.40. Now prevailing F 12 = C$2.50; T = 1year; R (riskless Canadian rate) = 5% CC. Value of Forward contract now = C$0.095 versus at contract inception of 0.

54 Contractual F vs. Prevailing F Contract. F: that specified in the contract Prevail. F: that which renders the value of the contract = zero. Heretofore: Contract. F = Prevail. F ergo no money changes hands at inception If contract. F not = prevail. F, money changes hands at inception Who pays whom? How much is paid?

55 2 nd interpretation: Buy PS 1-year forward Prevail. F = C$2.50 per PS Contract. F = C$2.40 per PS Canadian interest rate = 5% CC Firm must pay bank upfront $0.095 per PS The same formula has a different interpretation!

56 Value of sell forward post inception New versus original forward rates T = time remaining until contract expiration at new date R = domestic risk-free rate Another interpretation: F N is prevailing forward rate; F o is desired contractual rate.

57 Value of sell forward post inception FN FO S

58 Post inception sell forward example Sold13-month sterling forward a month ago at then prevailing forward rate, F 13 = C$2.40. Now prevailing F 12 = C$2.50; T = 1year; R (riskless Canadian rate) = 5% CC. Value of Forward contract now = - C$0.095 versus at contract inception of 0.

59 2 nd interpretation: Sell PS 1-year forward Prevail. F = C$2.50 per PS Contract. F = C$2.40 per PS Canadian interest rate = 5% CC Firm must pay bank –C$0.095 per PS upfront, i.e. bank must pay firm C$0.095 per PS upfront. The same formula has a different interpretation!

60 Coberturas Mexicanas Forward contract on greenbacks denominated in Mexican pesos. Price fixed in the contract is not the prevailing forward rate but the spot rate, So, at the contract’s inception. Since usually F>So, an up-front fee, of PV(@Rm)(F-So) is imposed for compra de cobertura (buy) contract.

61 Compra (buy) de Cobertura Buy U$1,000 9-month cobertura. F (9-month) = MP10. So (at contract inception) = MP9.70. Mexican riskless rate (CETES) = 15%EAR. Up-front fee payable by firm to bank = MP270 = PV of U$1000 x (10-9.7).

62 Venta (sell) de Cobertura Sell U$1,000 9-month cobertura. F (9-month) = MP10. So (at contract inception) = MP9.70. Mexican riskless rate (CETES) = 15%EAR. Firm must pay the bank an up-front fee of -MP270 = PV of U$1000 x (9.7-10). Up-front fee of MP270 firm receives from bank

63 Derivatives Pricing Problem Case in Transactions Exposure. Customer wants to sell DM125,000 5- month forward at rate of U$0.36 when prevailing forward is U$0.353. What price to charge customer? U$848. Price = U$(0.36-0.353)x125,000xPVfactor. Riskless rate,7.5%, is appropriate.

64 Derivatives Pricing Problem Customer also wants to buy a put on 125,000 DM’s 5 month maturity. Price of call with identical terms, C = U$0.01 x 125,000 = U$1,250 Option collar (P-C), replicates previous forward contract. P – U$1,250 = U$848. Thus, P = U$2,098.

65 FX Bid-Ask Spread Bank is willing to buy FX at Bid. Bank is willing to sell at (is asking) Ask. Terms adopt bank’s perspective. Hedging firm must buy FX at higher Ask and sell FX at low Bid. Buying one currency means selling the other currency. Implies: Bid in one currency is the Ask of the other currency.

66 FX Bid-Ask Spread (transactions cost) % round trip cost = (1-(bid/ask)). Bid on U$ = C$1.48; Ask = C$1.51. Implies Bid on C$ = 1/C$1.51; Ask = 1/C$1.48. (1 – (1.48/1.51) ) = 2% = (C$1,000- C$980.13)/C$1,000. C$1,000 to U$662.25 (=C$1,000/C$1.51)to C$980.13 (=U$662.25xC$1.48).

67 Case: Options Trip Hiro Goto Japanese exporter wanted to hedge U$10M receivable via a put option. Finance put premium by issuing a call. 3C=P; C

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68 Hiro’s Hedge: Options Collar S(JY/U$)JY125 Buy put on U$10M Sell call on U$30M

69 Hiro’s “Hedged” Cash Flow 125135 What eventuated!

70 Gomenasai! (Sooo sorry!) What Japanese exporter learned: By setting up an option collar, the up-front hedging outlay was reduced to zero, but the potential for a down-the- road opportunity cost was created. The potential opportunity cost eventuated! Pity! Hiro insidiously shifted from an option hedge to a type of forward hedge.

71 Black-Scholes Model for Valuing FX Options Applies only to European, not American, type. Forward rate version: employs forward rate with maturity same as that of option. Spot rate version: employs spot rate at time option is purchased. Also, foreign risk-free rate. Variables common to both models: X, exercise price; T, time to expiry; R D, domestic risk-free rate; volatility (standard deviation) of the continuously compounded rate of appreciation.

72 BS Model, Forward Rate Version C = Call premium; P = Put premium N(d 2 ) – probability call exercised N(-d 2 ) – probability put exercised

73 Use numa.com or deltaquants.com calculator to implement Forward Rate Model Under calculators click options Stock price or spot = Forward rate Interest rate and Dividend yield both = Domestic risk-free rate. Exercise or strike price, Time to expiry, and Volatility defined as given.

74 Forward rate model example Value a call option on SFR (South African Rand) 1 M with X = C$0.65, 1-year F = C$0.70, Canadian risk-free rate = 10% CC, and volatility (standard deviation) = 24.8%. Numa: 0.084/SFR C = C$84,000. Deltaquants: 0.086/SFR C = $86,000. By selling SFR forward now can lock-in future profit of $50,000 = (.70 -.65) 1M

75 BS Model, Spot Rate Version C = Call premium; P = Put premium R F – foreign risk-free rate, plays role of dividend-yield of stock on which stock option is written.

76 Use numa.com or deltaquants.com calculator to implement Spot Rate Model Under calculators click options Stock price or spot = Spot rate Interest rate = Domestic risk-free rate Dividend yield = Foreign risk-free rate. Exercise or strike price, Time to expiry, and Volatility defined as given.

77 Spot rate model example Value a call option on SFR (South African Rand) 1 M with X = C$0.65, S = C$0.68, Canadian risk- free rate = 10% CC, SFR risk-free rate = 7% CC and volatility (standard deviation) = 24.8%. Numa: 0.084/SFR, C = C$84,000. Deltaquants: 0.086/SFR, C = C$86,000. Both BS models yield same value iff interest rate parity (to be discussed) holds.

78 Adjusting for BS in the BS model (or applying the model to the real world) BS model assumes no transactions costs (no bid- ask spread). Thus, use average of bid and ask rates as the FX rate. This applies to both spot and forward rates. BS model assumes ability to borrow and lend at the same interest rate. Thus, use average of deposit and borrowing rates as the interest rate. This applies to both domestic and foreign interest rates.

79 Interest Rate Parity Theorem Based on financial arbitrage. Assume 1 year period. Domestic investment/financing: (1+R D ). Forward hedged foreign investment/financing: (1+R F )(F/S). Equality must hold.

80 Interest Rate Parity: Formulas

81 Interest Rate Parity: Intuition IRP: a statement about what holds in equilibrium. A high interest rate currency, FX, trades at a forward discount. Why? Otherwise, if it traded at a forward premium it would be an attractive investment for everyone. A low interest rate currency trades at a forward premium. Why? Otherwise, if it traded at a forward discount it would be an attractive financing venue for everyone.

82 Interest Rate Parity: Numerical Example Current spot rate on greenback = C$1.35 2-year forward rate on greenback = C$1.41 (this is usually the unknown) R canadian = 7% CC R u.s. = 5% CC Greenback trades at a forward premium because it is the low interest rate currency.

83 Interest Rate Parity: How many variables? How many variables do you see? In reality, 8 not 4! Domestic borrowing, deposit rates. Foreign borrowing, deposit rates. Bid, ask spread on spot. Bid, ask spread on forward.

84 Money market hedging Application of interest rate parity theorem. Synthesize a forward contract with 3 transactions: buy (sell) FX in spot; borrow(lend) in domestic currency; lend(borrow) in FX. Why? May be able to enhance cash flows compared with outright forward contract.

85 Enhance cash flows? If have an FX liability, may be able to buy FX at a lower rate than F, I.e., decrease outlays. If have an FX receivable, may be able to sell FX at higher rate than F, I.e. increase inflows. FX liability: Borrow domestic, buy FX spot, invest foreign synthesizes buy outright forward. FX receivable: Borrow foreign, sell FX spot, invest domestic synthesizes sell outright forward.

86 MMH: 2 complementary interpretations Create an offsetting FX cash flow: if FX receivable, create FX outflow; if FX payable, create FX inflow. Advance FX transaction date: instead of forward transaction, perform spot transaction now.

87 Money market hedge: numerical example Canadian firm will receive U$1M 6 months from now. S bid = C$1.38; F bid (6 months) = C$1.39. U$ borrowing rate = 8% APR Canadian deposit rate = 10% APR If use outright forward will receive C$1.39 6 months hence. Can you enhance this?

88 Is a money market hedge better? Borrow U$1M/1.04 = U$0.9615M Sell U$’s in spot, receive C$1.3269M Invest C$’s at C$ deposit rate, receive after 6 months C$1.3269M x 1.05 = C$1.3933M Payoff U$ loan U$0.9615 x 1.04 = U$1M with projected receivable. Note: U$ loan principal designed to achieve this. Money market hedge superior by C$3,300.

89 Money market hedge: FX liability Canadian firm has a liability of PS(sterling)1M due a year hence. F ask (1 year) = C$2.40; S ask = C$2.30. Canadian borrowing rate=7% APR or EAR UK deposit rate=4% APR or EAR Which is better? Buy outright forward or construct a money market hedge?

90 Buy forward or MMH? If buy PS forward (outright), pay C$2.4M a year hence. If construct money market hedge, pay synthesized forward rate, F MMH = C$2.37 per PS or C$2.37M a year hence. Save C$30,000 by constructing MMH. MMH steps: borrow C$, buy PS spot, invest PS.

91 MMH transactions: FX liability Now: Borrow (2.3)PS1M/1.04=C$2.21M Buy PS spot C$2.21/2.3=PS.96M Invest PS at 4% After 1 year: Close out PS deposit, obtain PS.96(1.04)=PS1M; this is used to meet liability. Pay off C$ loan, i.e., C$2.21M(1.07) = C$2.37M = PS1M(F MMH )

92 Option collar as synthetic forward Same exercise price for both put and call. Buy put & sell call synthesizes sell forward. Sell put & buy call synthesizes buy forward. F oc = synthetic forward rate Apply buy low & sell high rule. Hedge FX receivable: higher is better. Hedge FX payable: lower is better.

93 Forward rate synthesized with option collar C, P = call, put premiums with common X. FV = future value using domestic rate borrowing (if initial cash flow negative) or deposit (if initial cash flow positive).

94 FV calculation Initial CF < 0, use borrowing rate Initial CF > 0, use deposit rate Rationale: Initial cash flow, minus the deposit or plus the borrowing, must be zero. Why must the initial cash flow be zero? Because we want to be noughty!, i.e. To make the option collar a synthesized forward contract. Recall that a forward contract, whose contractual rate equals the prevailing forward rate, has a value of nought at inception.

95 Sell outright forward or option collar? Canadian with U$1M receivable due 6 months hence. Canadian deposit rate = 7% APR 6-month forward rate on U$ = C$1.39 X=C$1.37: Per U$ P = C$0.09, C = C$0.14 F oc =C$1.42 ergo rather than sell outright forward, F oc it!

96 Option collar transactions now Buy put, -C$0.09M Sell call, C$0.14M Invest initial net cash flow of C$0.05M in bank account, -C$0.05M Note: If initial net cash flow is < 0, must finance it. Ergo, use borrowing rate.

97 Option collar cash flows after 6 months Receive exercise price, C$1.37M, for sure either exercise put or the call gets exercised against you (Canadian firm). Deliver U$1M with projected receipt Close out bank account, receive C$0.05Mx(1.035) = C$0.05175M Net CF = C$1.42M > Foutright = C$1.39M

98 Hedging Protocol Determine best forward hedge: outright, MMH, or OC. Put your best forward forward. Compare best forward hedge with option, I.e., calculate B = breakeven rate. Example case: ¡Yo quiero Taco Bell!

99 2 nd Generation FX Options Designed to reduce up-front hedging cost: 1. Asian- underlying variable is not spot rate at a point in time in future by average spot rate over an interval of time. 2. Barrier- barrier must be crossed for the option to be created or cancelled. 3. Compound- option on an option or option conditional on some event.

100 Asian Options Appropriate for a firm that receives or pays a continuous stream of FX cash flows. E.g., firm receives EUR1M monthly. How to hedge for one year? 1. Twelve put options, each on EUR1M or 2. One Asian put on EUR12M for the entire year. Note: lower volatility ergo lower premium, i.e., hedge 2 is cheaper.

101 Pros & Cons of Asian put hedge Pro: cheaper due to lower volatility of underlying asset. Reason: law of large numbers. Con: the risk you are hedging against is not quite the same as the risk to which you are exposed. Example: At end of Jan, you are exposed to S Jan, but you hedge against risk of S Average and hedge payoff occurs at year-end not end of January.

102 Why are Asian options European? Asian option’s payoff depends on average spot rate during option’s life Must arrive at expiration date of option to determine average spot rate Cannot determine payoff until expiry Asian options are not American Asian options are European

103 Barrier Options New parameter B, the barrier, is defined. If B is crossed (spot rate = B), the trad.option is either created or cancelled automatically. Creation/Cancellation occurs only once during life of option. Premium is lower than traditional option. Why? Trad.option may not exist initially or trad.option may be prematurely cancelled.

104 Barrier Options Up vs. down: Will FX rate, S, rise or fall to barrier? Up: So B. In vs. out: Will the FX option be automatically created or cancelled? Put vs. call? Total of 8 types but only 2 are viable hedges. Down & in puts, up & in calls make sense. Why? Option hedges are created only when needed!

105 Barrier Puts Hedge FX receivable; adverse event: S drops B < So: Down & in – created when needed; Down & out – cancelled when needed. So < B: – Up & in – created when not needed; Up & Out – cancelled when not needed but exposure to zig-zag behavior remains. Conclusion: only Down & In Puts make sense as hedges. Outs are out! Some Ins are in!

106 Hedging FX receivable with a barrier put Down & in put is the only one viable hedge. Lower premium compared to traditional put. Beware Up & out puts! Why? Exposure to zig-zag behavior in FX rate. If FX rate rises past barrier, the Up & out put is canceled. If FX rate then drops, you’re exposed!

107 Down&In versus trad. Put payoff B

108 Barrier Calls Hedge FX payable; adverse event: S rises B < So: Down & in – created when not needed; Down & out – cancelled when not needed but exposure to zig-zag behavior. So < B: Up & in – created when needed; Up & out – cancelled when needed. Conclusion: only Up & in Calls may sense as hedges. Outs are out! Some Ins are in!

109 Why are out barrier options not suitable for hedging an FX liability? Outs are out for 2 distinct reasons. Up & out call: hedge is cancelled precisely when needed. Down & out call: exposure to zig-zag behaviour in the spot rate remains, i.e., S drops, call is cancelled, then S rises. Now you are exposed!

110 Hedging FX payable with a barrier call Up & in call is the only one viable hedge. Lower premium compared to trad.call. Beware Down & out calls! Exposure to FX zig-zag behavior. If FX rate drops below the barrier, the down & out is cancelled. If S then rises, you are now exposed!

111 Up&In versus trad. Call payoff B

112 Compound Options Option on an option: call on trad.call (for FX liability) or call on trad.put (for FX receivable). Event-contingent options: option is created only if event occurs. Cross-border tender offer: use takeover contingent FX call. Bid on foreign project: use FX put contingent on bid winning. Lower up front premium.

113 What compound options are appropriate hedges? Situation: submit a bid to construct expressway in Djakarta (Indonesia). Buy call on a trad.put on the Rupiah Buy event-contingent put on the Rupiah where “event” is defined as your winning the contract.

114 Why are premiums lower for the two compound options? Call on a put has lower value than the underlying traditional put. Premium on bid-contingent put is approximated by the following product: (premium on traditional put) X (probability of winning the bid).

115 (compound)call on trad.put vs. trad.put Hedge FX receivable Call on trad. put has lower up-front cost Analogy to stock purchase: buy stock vs. buy call then possibly exercise the call (latter: purchase in 2 installments) Protection required only if S drops Greater flexibility with compound call: exercise the call only if S drops

116 Hedge FX payable Call on trad.call has lower up-front cost Analogy to stock purchase: buy stock vs. buy call then possibly exercise the call (latter: purchase in 2 installments) Protection required only if S rises Greater flexibility with compound call: exercise that call only if S rises (compound)call on trad.call vs. trad.call


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