Derivatives Summary

Hedging Strategies

  • Introduction:
    • Derivative hedges: Forward, money, futures, and options markets.
    • Physical hedges

Money Market Hedge

  • Set-up (on order date):
    • Importers: Borrow in domestic, lend in foreign, buy foreign currency in the spot market.
    • Exporters: Lend in domestic, borrow in foreign, sell foreign currency in the spot market.
  • Advantages:
    • Perfect hedge to eliminate FX transaction risk.
    • Flexibility: can be unwound or rolled-forward easily.
  • Disadvantages:
    • Highest cost of physical market hedges.
    • Need access to domestic and foreign money markets.

Derivatives

  • Definition: A financial contract whose value is derived from an underlying asset or commodity.
  • Types:
    • Futures/Forwards: Obligation to buy/sell at a specified future date.
    • Options: Right (not obligation) to buy (call) or sell (put) within a specified time.
    • Swaps: Exchange of cash flows between parties based on predetermined terms (e.g., interest rate/currency swaps).
    • Contracts for Differences (CFDs): Speculate on price movements without owning the asset, settling the difference between contract opening and closing.
  • Purposes: Investment, speculation, and managing financial risk (e.g., currency and interest rate risks).
  • Risks: Market, counterparty, and liquidity risk.

Futures

  • Definition: Predetermined price, specified future date
  • Purposes: Hedging and speculating.
  • Features:
    • Standardization (size, date, asset).
    • Margin requirements.
    • Leverage (amplification of gain/loss).
    • Mark-to-market (settled daily).
    • Settlement (physical delivery or cash).
  • Traditionally in commodity markets: sugar, wheat, coffee, meat, oil, and metals.
  • Prices affected by:
    • Uncertainty in supply and availability.
    • Weather-dependent crop yields.
    • Demand and scarcity of metals.
  • Trade in contango, but can shift to backwardation when scarcity/demand is high.

Forward Contract

  • Definition: OTC agreement between buyer and seller.
  • Features:
    • Customization: Meets specific needs (quantity, price, date).
    • Private Agreement: OTC (no exchange).
    • Limited Liquidity: Difficult to enter/exit.

FX Rate Structure

  • Bid: Rate when selling domestic currency and buying foreign currency.
  • Offer: Rate when buying domestic currency and selling foreign currency.
  • Spot: Rate for dealing and settling today.
  • Forward: Rate for dealing today but settling in the future.
  • pm: Premium of the spot rate over the forward rate (in pips).
  • ds: Discount of the spot rate to the forward rate (in pips).
  • $/£: US Dollars (foreign) per UK Pound (domestic).
  • Rates quoted to 4 decimal places (pips).
  • Spread: Difference between bid and offer rates.
  • Calculation:
    • To calculate forward rates:
    • deduct premiums (pm) from the spot rate.
    • add discounts (ds) to the spot rate.
  • If a UK company wants to buy 100,000 settlement today:
    • Deal at the spot bid rate (1.5995)
    • £’s payable today => 100,000 ÷ 1.5995 = £62,520(tonearest(to nearest£)
  • If a UK company wants to sell 100,000 settlement in one month:
    • Deal at the 1 month forward offer rate (1.5815)
    • ££’s receivable in one month => 100,000÷1.5815=£63,231100,000 ÷ 1.5815 = £63,231 (to nearest ££)

FX Rate Movements

  • Short term:
    • Volatile.
    • Unpredictable.
  • Long term:
    • Determined by relative macro-economic growth.
    • Impacts inflation and interest rates.
    • ££ stronger / =$ weaker
    • £weaker/weaker /=$ stronger

Options

  • Definition: Financial instrument that gives the buyer the right, but not the obligation:
    • To buy or sell.
    • A quantity of an underlying item.
    • With the price fixed under the option agreement.
    • Either on a particular date or between set dates.
  • Types:
    • Call option: Right to buy.
    • Put option: Right to sell.
  • Strategies (https://www.optiontradingtips.com/strategies/):
    • Long (Buying) a CALL = the right to buy at the strike price. (Bullish – anticipate a rising market)
    • Selling (short) a CALL = the obligation to sell at the strike price (Bearish – anticipate a falling market)
    • Buying (long) a PUT = the right to sell at strike price (Bearish – anticipate a falling market)
    • Selling (short) a PUT = the obligation to buy at the strike price (Bullish – anticipate a rising market)
    • Long = Buying the option
    • Short = Selling the option
  • Market Hedge
    • Set-up:
      • Buy or sell currency options on the order date either:
        • on exchange – cheaper, but only certain pairs and hedge efficiency issues; or
        • over-the-counter – more expensive, but any currency pair and can achieve a perfect hedge
    • Advantage:
      • Options cap rather than fix prices:
        • protect against adverse FX rate movements; and
        • offer some benefit from favourable FX rate movements
    • Disadvantages:
      • The most expensive hedging method
      • Less liquidity than futures markets
      • Complex pricing mechanism introduces additional risks
  • Purpose: To hedge share price risk, foreign exchange risk, and interest rate risk, OR to gain exposure to these markets.
  • Exercise Price: The price at which the option holder has the right to buy or sell the particular item.
  • Exercising an Option:
    • Choice to exercise the option or let it expire.

Option Premium

  • Definition: The cost of buying an option; needs to be considered when deciding whether to exercise the option.
  • Example:
    • Exercise price – 130p
    • Share price 100p – the option would not be exercised here, as the current share price is less than the exercise price. The option holder loses £1500£1500 in total (just the option premium).
    • Share price 140p – the option could be exercised, giving a gain of (140-130) = 10p per share. However if we take off the option premium of 30p per share, the option holder makes a loss of (5000 shares*20p) = £1000£1000.
    • Share price 190p – the option could be exercised. This would give the holder a gain of (190-130) = 60p per share. Take off the premium of 30p per share, to give a gain of 30p per share * 5000 = £1500£1500 overall.

Derivative Hedges Compared

  • Hedging FX Transaction Risk with Derivatives
  • External Hedging Strategies Compared *Selection Criteria:
    • Available?
      *Explicit costs
      *Flexible?
      *Efficient?
      *Fix or cap?
      *Complex?
      *Hedging using options (summary)
      *Forwards
      *Money Market
      *Futures (exchange)
      *Options (exchange)
      *Options(OTC)