Introduction to Hedging and Derivatives

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[...] Dayton Manufacturing (revisited) Spot exchange rate 1.7640 $/Pound Three month forward: 1.7540 $/Pound Interest rate UK: Interest rate US: Company Cost of capital: 12% June OTC put option, strike 1.75 $/Pound premium June OTC put option, strike 1.71 $/Pound premium Dayton buys a Put option on pounds June OTC put option, strike 1.75 $/Pound (at-the-money) premium Premium (paid in March) = (size of option) x (Premium) x (spot rate) = Pound1M x 1.5% x 1.7640 = $26,460 Future value of the premium cost in June $26,460 (1.03)=$27,254 Money Dayton makes depends on the spot rate at settlement date in June If the rate is above 1.75 $/Pound, Dayton will not exercise the Put and exchange the Pound1M at the spot rate If the rate is below 1.75 $/Pound, Dayton will exercise the Put, receiving $1,750,000. [...]

[...] American options European potions can only be exercised on the expiration date American options can be exercised at any time, including expiration date American options usually worth more than European options, other things equal In-the-money, positive payoff is exercised today for a call = S>K for a put = SK Options a Hedging Instrument Hedging with options allows for participation in any upside potential associated with the position while limiting downside risk. Asymmetric risk protection compare with forward contract and money market hedge; these provide symmetric risk protection. Choice of option strike prices is an important aspect of utilizing options as option premiums and payoff patterns will differ accordingly. [...]

[...] Firm borrows in one currency, converts it to another, invests that currency. When loan comes due, firm receives payment from its operations and uses that money to repay the loan. Cost measured by the difference in interest rates If CPI holds, interest differential = forward premium/discount result same as cost of forward hedge Dayton Case: Money Market Hedge Determine value of Pound that must be borrowed today that can be repaid with the A/R of Pound1M in 3 months: Pound975,610 (=Pound1M/1.025) at 10% exchange for $1,720,976 at spot rate 1.7640 $/Pound invest in US at receive in 3 months $1,746,790 (=$1,720,976*1.015) What is the implied forward rate? [...]

[...] Which one is better? Currency Options An option gives holder the right to buy (call) or sell (put) an asset stocks: Goggle; Aventis; Total foreign currency: Euros; Yen stock indices: CAC40; DAX On (European option) or before (American option) some predetermined date expiration date At a certain price strike price Call Option Contract: example Buy call option of Euro1,000 at $1.50 in 3 months, cost of option = $50 quantity: Euro1,000 strike price $1.50 call price C = $50 time to maturity: 3 months payoff of a call: C = max(S-K, profit = payoff - C Put Option Contract: example Buy put option of Euro1,000 at $1.50 in 3 months, cost of option = $50 quantity: Euro1,000 strike price $1.50 put price $50 time to maturity = 3 months payoff of a put: P = max(K-S, profit = payoff - P Symmetry Between Call and Put Options Symmetry between "call options on Pound" in US and "put option on in UK represent right to pay $ and receive Pound, "Pound call" or put" $ payoff of a call of Pound1 with strike price K($/Pound) C = max(0,S($/Pound)-K($/Pound)) Pound payoff of a put on with strike price 1/K($/Pound) P = max(0,1/K($/Pound)-1/S($/Pound)) Thus, we have: C/S($/Pound)K($/Pound) = P C/S($/Pound) = PK($/Pound) Meaning the Pound payoff a call on Pound1 with strike price K($/Pound) is the same as payoff of a put on K($/Pound) with a strike price 1/K($/Pound) = K(Pound/$) Replicating Forward Payoff with Call and Put Options We can write: S = max(0,S-F)+min(S,F) Equivalent to: S = max(0,S-F)+F-max(0,F-S) We can replicate payoff of buying forward by buying a call and selling a put with strike price S-F = max(0,S-F)-max(0,F-S) Option Contracts: Preliminaries European vs. [...]

[...] Introduction to Hedging and Derivatives Hedging with forwards: Contract where 2 parties agree on the price of an asset today, to be delivered and paid at a future date. legally binding on both parties can be tailored to meet needs of both parties positions Long: agree to buy the asset at the future date Short: agree to sell the asset at the future date forwards negotiated contracts, no exchange of cash so usually limited to large creditworthy corporations Entering into forward contract can virtually eliminate price risks does not completely eliminate it only if uncertainty concerning quantity (counterparty risk) As it eliminates price risk, prevents firm from benefiting if prices moves in company's favour. [...]