Hi I have 2 queries in pilot paper Q2 Sydonics Engineering:
I couldn’t understand ” The current Euro/sterling exchange rate is EUR 0.6900 to the pound” means 1euro=0.69 pounds (direct quote)?
When I first looked at this I though: euro/sterling=euro0.69/1pound, obviously I was wrong, but why?
(b)(ii)how to caculate the No of contracts?
Now you know why they ended up removing the examiner!!!
EUR 0.6900 to the pound does mean what you write – it means it in normal English and it is the way it is usually meant. The examiner was quite simply wrong.
With regard to the number of contracts, this is an example of a delta hedge.
If you look at the formula for a call option price, then it starts off with the term Pa N(d1).
This means that (in the very short-term) if the price changes then the price of the call option changes by N(d1) times it.
I know these are not shares, but just to try and make the point, if N(d1) is equal to (say) 0.2. Then if Pa (share price) changes by $1, then the price of the call option only changes by 0.2 x $1 = $0.2.
If we want any profit on our options to be the same as any loss on our shares, then we need to have 5 times as many options as we have shares. i.e. 1 / 0.2.
In general terms it is 1 / N(d1). We call N(d1) delta, and the exercise is a delta hedge.
Just need a little further explanation on the no. of contracts.
Why in this question, it is different from the way we usually calculate? i.e. (Payment or receipt amount)/(contact size) , where there’s no delta hedge involved.
I’m guessing that in this instance, they are not going to exercise the option, but are trying to use the gain/loss on option to offset against the actual exchange?
While in the usual method the option are to be exercised.
Hope i’m right.
Thanks again, appreciate your time and effort.
Yes – you are correct.
Instead of using options in the usual way and then exercising (or not exercising them), then are using the gain or loss on them to hedge against the effect of changes in the exchange rate.
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