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European and American option
what we will do with the overhedged amount in this example in net flows
premium is 5,555
amount hedged is
31250*22=687,500amount (over) / under hedged
1,000,000-(31250*22*1.475)=(14,062.5)$ (at which rate should we convert it?)what will be effect on net flows?
687,500amount hedged – 5,555premium paid and should we take any effect of over hedged amount? should we need to subtract it as we add under hedged amount converted at transaction date?
Sir
also please tell me whether FOREX swaps are included in the syllabus?
thank u in advance
in the technical article of currency swap
will the end analysis of barrow would be like this?
without swap EURIBOR+1.5% . lets say EURIBOR is 4 %
interest is 5.5% *500 euro=27.5 million
with swap
500 euro*3.9%=19.5m+ .2% bank fee=20.5
principle amount swapped back five years later at the same spot rate of 1.1200. and interest payments are remitted each year at which rate?
First question:
Over/under hedging is only applicable when using futures, not with options. (With traded options the options do not involve converting money and with OTC options the quote will be for the exact amount).
Second question:
Yes.
Third question:
The interest payments are not converted – the whole point of the swap is that they want to borrow money in a foreign currency to finance a foreign investment. The interest will be paid out of the earnings from the foreign investment.
(I assume that you are watching my free lectures on foreign exchange risk management? There is no point in using the notes without watching the lectures because it is in the lectures that I explain and expand on the notes.)
Sir i am watching your lectures but in kaplan they are calculating it on options.
here is the link of the kaplan chapter
https://kfknowledgebank.kaplan.co.uk/KFKB/Wiki%20Pages/ACCA%20P4%20Chapter%2013.aspx
in this PONGO example TYU 4.
in future we leave the transaction at risk and on the date of of transaction we calculate gain / loss on futures and convert the amount and gain/ loss at spot rate given on date of transaction.
futures are fixed size contract so under/over hedged of risk is there.in options we leave the transaction at risk. and on the date of transaction we convert amount at the prevailing spot rate. if option is exercise we calculate gain / loss on the option which is difference of current spot rate and exercise price. but in options the units are also fixed like in example 3 its 31,250. so why we are not calculating over/underhedged amount?
(i dont understand this point of converting money with traded options)and in one of your discussion you mentioned this
https://opentuition.com/topic/under-and-over-hedge-options/
“in terms of getting the marks, it is a minor point.
It is simply that because with futures and options the deal has to be in fixed size contracts, then the amount hedged is unlikely to be exactly the same as the amount of the actual transaction. Therefore they will end up hedging a bit too much or a bit too little.
The amount of the over or under hedge is therefore still at risk of exchange rate movements (although this could be eliminated by using a forward rate on the amount).”
at the end please tell me what will be the effect of overhedged amount on net flows. do we need to subtract it? should we treat it as a gain thing and convert at the rate which give us less benefit in terms of money (the rule)
i know its a minor point but sometimes 2 marks are life saving in exams.
thank you in advance
Sorry – I should have worded my previous answer better.
The problem with traded options is this: the transaction itself is converted at whatever the spot rate happens to be. If (and only if) the option is exercised then there will be a gain on the options which offsets what is being lost on the spot rate.
Because of the contract size, this gain from the options will not exactly equal the loss on the transaction so there will end up being effectively an over or under hedge. If they wanted, the company certainly could cover this by using the forward rate on the over or under hedge.
However, if the spot rate were to move in the company’s favour and therefore the option was not going to be exercised, then it would in retrospect have been pointless to have used the forward rate on the over/under hedge.
For this reason, although you could mention the problem in an exam answer, you would not be expected to do calculations on it in the exam. The time it would be nice to do calculations is when the exercise is on futures rather than on options.Thanks alot sir now i am very clear on this 🙂 and i really appreciate you answer each and every bit of my question.
you are the best 🙂
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