C2
Content
Treasury
IES
1
Hedging Strategies
Plain Vanilla Option Structure
Hedge 100% through forwards
Hedging Alternatives
Zero Cost Option Structure
Leave Exposure Unhedged
2
Forward Contract
Agreement to buy or sell a currency at a fixed price at a future date Advantages – Locks the corporate into a definite rate – Corporate immune to any further movement in currency markets Disadvantages – Does not let the corporate take advantage of any favorable movement in exchange rates
3
What is an option ?
An option contract confers the right, but not the obligation, to buy or sell a specific underlying
4
Type of Options
European Style
These options can only be exercised at the expiry date of the option.
American Style
These options can be exercised at any time prior to, and including expiry.
5
Currency Options in India
Use of cross- currency an Re USD options for hedging forex liabilities is allowed – Corporates can use option structures for hedging identified exposures as long as they do not receive net premia – Banks are allowed to use call or put options to hedge their trading book – Small volumes with foreign banks performing the sales function for their overseas books Cross-currency options can be embedded in currency swaps
6
Plain Vanilla Put Option
Spot: 43.50 3m Forward: 43.60 Market Cost of the option: 30 paise
Summary : Call at strike = 43.60 The worst case is protected at 43.60 If spot at maturity is less than 43.60, client can sell USD at 43.60 If spot at maturity is more than 43.60, client can sell USD at then prevailing spot rate Cost of the option: 30 paise Therefore effective worst case for the client = 43.30 When would the client want to buy option rather than a forward
7
Plain Vanilla Call Option
Spot: 43.50 3m Forward: 43.60 Cost of the option: 30 paise
Summary :
The worst case is protected at 43.60 If spot at maturity is more than 43.60, client can buy USD at 43.60 If spot at maturity is less than 43.60, client can buy USD at then prevailing spot rate Cost of the option: 30 paise Therefore effective worst case for the client = 43.90 When would the client want to buy option rather than a forward
8
What determines option premium ?
Spot Price
Option Value
Strike Price
Volatility
Option Valuation Models
Time
Interest Rate
Risk Measures
9
Vanilla Call Option
Spot: 43.50 3m Fwd rate: 43.60
Client buys call at 43.60 Cost of the option is 30 paise per USD Payoff at maturity:
Spot scenarios Payoff of a forward Payoff of the option Payoff compared to forward
10
42.50 43.00 43.50 44.50
45.00
46.00
Concept of Zero cost structure
Spot: 43.50 3m forward: 43.60
How
does the cost of option become zero?
Under
plain vanilla option, client only BUYS the option Under Zero cost, client BUYS as well as SELLS the option Combination of buying and selling options makes it a zero cost structure
How
is the pay off different from plain vanilla option? vanilla option, there is only upside from the strike
Under
price Under Zero cost, there can be upside as well as downside
11
Spreads
– These involve bought and sold options of the same type
– The bought and sold legs would differ in one or more of:
Strike rate Notional amount (Vertical spreads) (Ratio spreads)
Tenor
(Calendar spreads)
– Typical spreads involve one bought and one sold options, but can have multiple numbers of each.
– Objective of a spread is to benefit from favourable movements in spot/volatilities in a restricted risk-return structure
12
Exporter Forward Extra
Spot: 43.50 12 month Fwd rate: 43.92
Client buys put at 44 Client sells call at 43.50
View:
Strong
view that Rupee would appreciate
Client
The
seeks protection
structure provides a pay off better than the prevailing forward rate if structure gives better payoff than even the 12m forward rate willing to accept some downside risk in lieu of the better pay off
the view comes out right
The Client
13
Structures –using vanilla options
Range Forward
– Exposure - USD payables 6 mth (i.e. short USD/INR)
– Spot reference - 48.00 (say)
– Buy USD call INR put 49.50 6 months
– Sell INR call USD put 46.50 6 months – Total premium payable - Zero
– Thus, rate fixed at 49.50 worst case, and 46.50 best case.
– In the “range” between these two rates, to access market rate.
14
Import- Benefit from Re app & protects from any sever depreciation
Market
Spot: 43.50 12 month Fwd
rate: 43.92
Client buys 1 mio Call at 43.60 Client sells 1 mio Put at 42.00 Client sells 2 mio Calls at 44.12
– At maturity if 43.60 < spot < 44.12, client is obligated to buy USD at 43.60 if 42 < spot < 43.60, client can buy USD at then prevailing spot if spot < 42, client is obligated to buy USD at 42 if spot > 44.12, client is obligated to buy USD at different rates depending upon the spot Breakeven point is 44.64 USD would not appreciate beyond a ‘cap’ level (44.12)
Protection
at a better rate than the forward level
15
Hedging in practice
Traders usually ensure that their portfolios are deltaneutral at least once a day Whenever the opportunity arises, they try to improve the gamma and vega As portfolio becomes larger hedging becomes less expensive
A scenario analysis involves testing the effect on the value of a portfolio of different assumptions concerning asset prices and their volatilities
16
Seagull
– Exposure - USD payable 6 mth (i.e. short USD/INR)
– Spot reference - 48.00 (say)
– Fwd rate (6 month) - 48.80 – Buy USD call INR put 48.50 6 months
– Sell USD call INR put 49.75 6 months
– Sell USD put INR call 47.00 6 months – Total premium payable - Zero – Thus, buyer has full protection for moves between 48.50 to 49.75. It buys at the market rate between 47.00 to 48.50. – However it has to pay if INR appreciates below 47.00 which is compensated by its gain on the underlying
17
Seagull
Option Payoff 48.50 Sell a USD Call Spot at Expiry Buy a USD Call 49.75
47.00
18
Exotic options
Options Barrier - Knock out One Touch Others
Exotic Combinations
Knockout Forwards Bonus Forwards Enhanced Forwards
19
One touch option
– Fixed payout when spot reaches trigger – The client receives USD 0.1 mio if USD/INR ever trades at or above 49.50 within next 6 months.
Option Payoff
48.00
Current Spot
49.50
Touch level
Spot at Expiry
20
Other exotics
Asian options Bermudan options Compound “As you like it” or Chooser Barrier options : Knockouts and Knockins Single barrier options Double barrier options Digital options Digital barriers Forward start options Lookback options
21
The right strategy
– If the intention is just to fix a rate for the future, a simple forward would suffice – If the company is willing to pay a premium to insure against adverse movement only, purchase of an option is the solution. This would leave favorable movements in rate untouched. – In order to reduce (or eliminate) the premium, the buyer can
forego part of upside by having K/O or K/I sell another option, covered by the underlying exposure
– The client’s view of the market will form the basic rationale behind the structure to use.
22
Regulatory guidelines
Forward contracts – Rebooking of cancelled contracts allowed for all exposures falling due within one year – Currency and tenor of hedge left to the choice of the customer Derivatives cannot be used to hedge derived exposures Once cancelled FC Re Swaps cannot be rebooked Swaps, options and forwards could be done with any bank
23
Documentary requirement
Proof of underlying- forward and derivative Board resolution ISDA
24
Black Scholes Model
Assumptions – European option – Log returns of stock are independent, stationary and
normally distributed
– Risk free is constant and same for all maturities – Absence of transaction costs – The path of currency spot price is continuous
25
Black Scholes – Counting the costs
Price formulae:
26
German-Kohlhagen Model ( r rf ) T F Se Forward price
c e
rT
[FN (d1 ) XN (d 2 )]
p e rT [ XN ( d 2 ) FN ( d1 )] ln(F / X ) 2 T / 2 d1 T d 2 d1 T
27
Managing the Greeks
– The Greeks provide the tools needed to manage options portfolios – Critical for portfolio risk monitoring – Delta gives the amount to hedge the spot risk at inception – Other portfolio risks to be managed: – Gamma
– Theta – Vega – Rho
28
Various Greeks
Delta -- Sensitivity to the spot rate Gamma -- Sensitivity to the delta
Vega -- Sensitivity to volatility
Theta -- Sensitivity to time Rho -- Sensitivity to interest rates
29
Delta hedging
Delta (D) is the rate of change of the option price with respect to the underlying Option price
B
A
Slope = D
Spot price
30
Other Greeks
Gamma (G) is the rate of change of delta (D) with respect to the price of the underlying asset Theta (Q) of a derivative (or portfolio of derivatives) is the rate of change of the value with respect to the passage of time Vega (n) is the rate of change of the value of a derivatives portfolio with respect to volatility Rho (Derivative w.r.t. interest rates) – Rho is the rate of change of the value of a derivative with respect to the interest rate – For currency options there are two rhos
31
Managing Delta, Gamma and Theta
Delta can be managed by taking a position in the underlying To manage gamma and vega, we need to buy/sell other options
32
Thank you
33
IES
1
Hedging Strategies
Plain Vanilla Option Structure
Hedge 100% through forwards
Hedging Alternatives
Zero Cost Option Structure
Leave Exposure Unhedged
2
Forward Contract
Agreement to buy or sell a currency at a fixed price at a future date Advantages – Locks the corporate into a definite rate – Corporate immune to any further movement in currency markets Disadvantages – Does not let the corporate take advantage of any favorable movement in exchange rates
3
What is an option ?
An option contract confers the right, but not the obligation, to buy or sell a specific underlying
4
Type of Options
European Style
These options can only be exercised at the expiry date of the option.
American Style
These options can be exercised at any time prior to, and including expiry.
5
Currency Options in India
Use of cross- currency an Re USD options for hedging forex liabilities is allowed – Corporates can use option structures for hedging identified exposures as long as they do not receive net premia – Banks are allowed to use call or put options to hedge their trading book – Small volumes with foreign banks performing the sales function for their overseas books Cross-currency options can be embedded in currency swaps
6
Plain Vanilla Put Option
Spot: 43.50 3m Forward: 43.60 Market Cost of the option: 30 paise
Summary : Call at strike = 43.60 The worst case is protected at 43.60 If spot at maturity is less than 43.60, client can sell USD at 43.60 If spot at maturity is more than 43.60, client can sell USD at then prevailing spot rate Cost of the option: 30 paise Therefore effective worst case for the client = 43.30 When would the client want to buy option rather than a forward
7
Plain Vanilla Call Option
Spot: 43.50 3m Forward: 43.60 Cost of the option: 30 paise
Summary :
The worst case is protected at 43.60 If spot at maturity is more than 43.60, client can buy USD at 43.60 If spot at maturity is less than 43.60, client can buy USD at then prevailing spot rate Cost of the option: 30 paise Therefore effective worst case for the client = 43.90 When would the client want to buy option rather than a forward
8
What determines option premium ?
Spot Price
Option Value
Strike Price
Volatility
Option Valuation Models
Time
Interest Rate
Risk Measures
9
Vanilla Call Option
Spot: 43.50 3m Fwd rate: 43.60
Client buys call at 43.60 Cost of the option is 30 paise per USD Payoff at maturity:
Spot scenarios Payoff of a forward Payoff of the option Payoff compared to forward
10
42.50 43.00 43.50 44.50
45.00
46.00
Concept of Zero cost structure
Spot: 43.50 3m forward: 43.60
How
does the cost of option become zero?
Under
plain vanilla option, client only BUYS the option Under Zero cost, client BUYS as well as SELLS the option Combination of buying and selling options makes it a zero cost structure
How
is the pay off different from plain vanilla option? vanilla option, there is only upside from the strike
Under
price Under Zero cost, there can be upside as well as downside
11
Spreads
– These involve bought and sold options of the same type
– The bought and sold legs would differ in one or more of:
Strike rate Notional amount (Vertical spreads) (Ratio spreads)
Tenor
(Calendar spreads)
– Typical spreads involve one bought and one sold options, but can have multiple numbers of each.
– Objective of a spread is to benefit from favourable movements in spot/volatilities in a restricted risk-return structure
12
Exporter Forward Extra
Spot: 43.50 12 month Fwd rate: 43.92
Client buys put at 44 Client sells call at 43.50
View:
Strong
view that Rupee would appreciate
Client
The
seeks protection
structure provides a pay off better than the prevailing forward rate if structure gives better payoff than even the 12m forward rate willing to accept some downside risk in lieu of the better pay off
the view comes out right
The Client
13
Structures –using vanilla options
Range Forward
– Exposure - USD payables 6 mth (i.e. short USD/INR)
– Spot reference - 48.00 (say)
– Buy USD call INR put 49.50 6 months
– Sell INR call USD put 46.50 6 months – Total premium payable - Zero
– Thus, rate fixed at 49.50 worst case, and 46.50 best case.
– In the “range” between these two rates, to access market rate.
14
Import- Benefit from Re app & protects from any sever depreciation
Market
Spot: 43.50 12 month Fwd
rate: 43.92
Client buys 1 mio Call at 43.60 Client sells 1 mio Put at 42.00 Client sells 2 mio Calls at 44.12
– At maturity if 43.60 < spot < 44.12, client is obligated to buy USD at 43.60 if 42 < spot < 43.60, client can buy USD at then prevailing spot if spot < 42, client is obligated to buy USD at 42 if spot > 44.12, client is obligated to buy USD at different rates depending upon the spot Breakeven point is 44.64 USD would not appreciate beyond a ‘cap’ level (44.12)
Protection
at a better rate than the forward level
15
Hedging in practice
Traders usually ensure that their portfolios are deltaneutral at least once a day Whenever the opportunity arises, they try to improve the gamma and vega As portfolio becomes larger hedging becomes less expensive
A scenario analysis involves testing the effect on the value of a portfolio of different assumptions concerning asset prices and their volatilities
16
Seagull
– Exposure - USD payable 6 mth (i.e. short USD/INR)
– Spot reference - 48.00 (say)
– Fwd rate (6 month) - 48.80 – Buy USD call INR put 48.50 6 months
– Sell USD call INR put 49.75 6 months
– Sell USD put INR call 47.00 6 months – Total premium payable - Zero – Thus, buyer has full protection for moves between 48.50 to 49.75. It buys at the market rate between 47.00 to 48.50. – However it has to pay if INR appreciates below 47.00 which is compensated by its gain on the underlying
17
Seagull
Option Payoff 48.50 Sell a USD Call Spot at Expiry Buy a USD Call 49.75
47.00
18
Exotic options
Options Barrier - Knock out One Touch Others
Exotic Combinations
Knockout Forwards Bonus Forwards Enhanced Forwards
19
One touch option
– Fixed payout when spot reaches trigger – The client receives USD 0.1 mio if USD/INR ever trades at or above 49.50 within next 6 months.
Option Payoff
48.00
Current Spot
49.50
Touch level
Spot at Expiry
20
Other exotics
Asian options Bermudan options Compound “As you like it” or Chooser Barrier options : Knockouts and Knockins Single barrier options Double barrier options Digital options Digital barriers Forward start options Lookback options
21
The right strategy
– If the intention is just to fix a rate for the future, a simple forward would suffice – If the company is willing to pay a premium to insure against adverse movement only, purchase of an option is the solution. This would leave favorable movements in rate untouched. – In order to reduce (or eliminate) the premium, the buyer can
forego part of upside by having K/O or K/I sell another option, covered by the underlying exposure
– The client’s view of the market will form the basic rationale behind the structure to use.
22
Regulatory guidelines
Forward contracts – Rebooking of cancelled contracts allowed for all exposures falling due within one year – Currency and tenor of hedge left to the choice of the customer Derivatives cannot be used to hedge derived exposures Once cancelled FC Re Swaps cannot be rebooked Swaps, options and forwards could be done with any bank
23
Documentary requirement
Proof of underlying- forward and derivative Board resolution ISDA
24
Black Scholes Model
Assumptions – European option – Log returns of stock are independent, stationary and
normally distributed
– Risk free is constant and same for all maturities – Absence of transaction costs – The path of currency spot price is continuous
25
Black Scholes – Counting the costs
Price formulae:
26
German-Kohlhagen Model ( r rf ) T F Se Forward price
c e
rT
[FN (d1 ) XN (d 2 )]
p e rT [ XN ( d 2 ) FN ( d1 )] ln(F / X ) 2 T / 2 d1 T d 2 d1 T
27
Managing the Greeks
– The Greeks provide the tools needed to manage options portfolios – Critical for portfolio risk monitoring – Delta gives the amount to hedge the spot risk at inception – Other portfolio risks to be managed: – Gamma
– Theta – Vega – Rho
28
Various Greeks
Delta -- Sensitivity to the spot rate Gamma -- Sensitivity to the delta
Vega -- Sensitivity to volatility
Theta -- Sensitivity to time Rho -- Sensitivity to interest rates
29
Delta hedging
Delta (D) is the rate of change of the option price with respect to the underlying Option price
B
A
Slope = D
Spot price
30
Other Greeks
Gamma (G) is the rate of change of delta (D) with respect to the price of the underlying asset Theta (Q) of a derivative (or portfolio of derivatives) is the rate of change of the value with respect to the passage of time Vega (n) is the rate of change of the value of a derivatives portfolio with respect to volatility Rho (Derivative w.r.t. interest rates) – Rho is the rate of change of the value of a derivative with respect to the interest rate – For currency options there are two rhos
31
Managing Delta, Gamma and Theta
Delta can be managed by taking a position in the underlying To manage gamma and vega, we need to buy/sell other options
32
Thank you
33
