Treasury

IES

Hedging Strategies
Plain Vanilla Option Structure

Hedge 100% through forwards

Hedging Alternatives

Zero Cost Option Structure

Leave Exposure Unhedged

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

What is an option ?

An option contract confers the right, but not the obligation, to buy or sell a specific underlying

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.
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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

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
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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
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What determines option premium ?

Spot Price

Option Value

Strike Price

Volatility

Option Valuation Models

Time

Interest Rate

Risk Measures

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
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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

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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
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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

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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.
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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

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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

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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
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Seagull
Option Payoff 48.50 Sell a USD Call Spot at Expiry Buy a USD Call 49.75

47.00

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Exotic options
Options Barrier - Knock out One Touch Others

Exotic Combinations
Knockout Forwards Bonus Forwards Enhanced Forwards

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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

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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
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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 clients view of the market will form the basic rationale behind the structure to use.
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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

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Documentary requirement
Proof of underlying- forward and derivative Board resolution ISDA

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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
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Black Scholes Counting the costs

Price formulae:

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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

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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

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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

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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
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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

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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

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Thank you

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