Hedging Flashcards
(37 cards)
Advantages / Disadvantages of Forward Contracts / FRAs
Advantages:
- Hedges downside risk
- Tailored to the investor
- Locks in rate (good for forecasting)
Disadvantages:
- Removes any upside
- Difficult to unwind
- Contract must be fulfilled
Advantages / Disadvantages of Futures
Advantages:
- Hedges downside risk
- More flexible as can close out position any time
Disadvantages:
- Removes any upside potential
- Standardised contracts so may over/under hedge
- Must post margin to the exchange
Advantages / Disadvantages of OTC Options
Advantages:
- Hedges downside risk
- Allows investor to benefit from upside risk by letting option lapse
- Bespoke to client
Disadvantages:
- Premium can be expensive
- No secondary market
Advantages / Disadvantages of Traded Options
Advantages:
- Hedges downside risk
- Can benefit by upside by letting option lapse
Disadvantages:
- Premium can be expensive
- Standardised contracts so may over/under hedge
How to calculate hedge efficiency
Gain or loss of hedging instrument / Gain or loss on the hedged item
Advantages / Disadvantages of Money Market Hedge
Advantages:
- Hedges downside risk
- Locks in price (good for forecasting)
- Tailored to the investor
(same advantages as forwards)
Disadvantages:
- Removes any upside
- Difficult to unwind
- More admin required
- Unlikely to be cheaper than using a forward rate
(same disadvantages as forwards but more expensive)
What are the 3 currency risks?
- Transaction risk (short term - changes in FX rates before settlement leading to loss or gain)
- Economic risk (long term - trading in particular country may make the company less competitive due to FX rates)
- Translation risk (danger of generating accounting losses when translating overseas subsidiaries)
Risks of trading overseas?
- Physical risk (goods lost or stolen in transit)
- Credit risk (payment default by customer)
- Trade risk (cancellation whilst goods in transit or refusal at delivery)
- Liquidity risk (inability to finance credit given to customers)
Currency futures:
How to calculate no. of contracts?
How to calculate profit/loss on futures?
Amount converted at CURRENT FUTURES price / contract size
Profit/Loss on futures x No. of contracts x Contract value
Then convert at SPOT RATE at end of hedge
Interest futures:
How to calculate no. of contracts?
How to calculate profit/loss on futures?
Loan amount / Contract size x No. of 3 months
% Gain / Loss x No. of contracts x Contract value.
Then multiply by 3/12!
How to calculate interest FRA?
1) Decide on what FRA is required (e.g. 3-9 FRA is a loan in months that lasts for 6 months).
2) The interest rate is the locked rate for the loan.
3) If loan interest is 5% but we locked in 4%, it would look like this:
Loan 5%
FRA -1%
Interest payable 4%
If we are receiving money, using MMH, do we deposit or borrow in foreign currency?
Borrow
Reminder: time apportion interest!
If we are paying money, using MMH, do we deposit or borrow in foreign currency?
Deposit
Reminder: time apportion interest!
Index futures:
How to calculate contract size for index’s?
How to calculate no. of contracts?
How to calculate profit/loss?
FTSE index future at start x £10
Portfolio value / contract size
Profit/loss x No. of contracts x £10
Index options:
How to calculate contract size for index’s?
How to calculate no. of contracts?
How to calculate profit/loss on option?
How to calculate premium?
FTSE strike rate at start x £10
Portfolio value / contract size
Profit/loss x No. of contracts x £10
Index points x £10 x No. of contracts
How to calculate outcome in FTSE hedge (if not provided)?
Portfolio value at start / FTSE index at start x FTSE value at close of hedge
Traded interest options:
How to calculate no. of contracts?
How to calculate profit/loss on option?
How to calculate premium?
Loan amount / Contract size x No. of 3 months
% Gain / Loss x No. of contracts x Contract value.
Then multiply by 3/12!
No. of contracts x Contract value x Premium % x 3/12
What does interest futures/strike price value represent?
100 - interest rate%
How to close out OTC Hedge? How are Put/Calls determined?
OTC is the only hedge that put/calls are decided by the action of the foreign currency!
1) Decide which is the better rate out spot and exercise price and convert.
2) Calculate premium and deduct/add as necessary
Traded currency options:
How to calculate no. of contracts?
How to calculate profit/loss on option?
How to calculate premium?
Amount converted at STRIKE PRICE / contract size
Profit/Loss on option x No. of contracts x Contract value
Then convert at SPOT RATE at end of hedge
No. of contracts x premium (cents) x contract size CONVERTED AT BUYING EXCHANGE RATE
If there is a bank overdraft, what to do if a premium is paid on hedge?
Calculate interest on premium using borrowing %
What is interest parity?
The idea that an investor will be in the same position if they were to:
- Deposit money in UK back account for a set period
- Exchange to dollars, deposit the money in a US bank for a set period, then exchange back to GBP using an FX forward
How to calculate interest parity?
1) Convert start amount at exchange rate (if given spread, take average)
2) Increase figures by average of deposit/borrowing interest rates (time apportion)
3) Divide future values to get forward rate
What is purchasing power parity?
Purchasing power parity is the idea that after the effects of the exchange rate, items will cost the same in each currency.
(Ignoring transaction fees).
