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Thank you for the great lecture (Foreign exchange risk management (2) Part 2).
In other exam papers I believe they use an alternative way to calculate the Currency options payable figure.
So for example 3 – We would calculate the no of contracts and premium as normal, but then we would calculate the amount over hedged = (22 x £31,250 x 1.475) – $1M = $14,062.50. Covert to £ using the spot rate (as the Forward rate is not provided) so $14,062.50/1.4120 = £9,959 (Receipt)The Net total to pay would then be (22 x 31,250) = £687,500 – £9,959 + £5,556 (premium) = £683,097.
This figure is slightly different from your figure of £683,128.
Can I use this method and if so why is there a difference?
Many Thanks
I do not know which other exam papers you are referring to.
The over or under hedged is a small point that will never carry many marks (and if you are short of time, then even just mentioning it without calculations will get a mark). If you are not given a forward rate, then it can not be hedged and so would have to be converted at whatever the spot rate it on the date of the transaction. Converting at the current spot rate would not really be sensible (although would not lose a mark at most).
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One of the examples of this is Gogarth – question 76 on the Kaplan exam kit which I worked through.
Expected receipt at a future date (31st Aug) was $22.9M. Using Sept Currency call options at exercise price of 0.2368 – purchase of MR 96,707,081.
Contract size: MR 500,000
No of contracts: 193.4 (use 193)Therefore amount under hedged was $22.9M – (193 x 500,000 x 0.2368) = $48,800
Sold using Forward rate: $48.800/0.2374 = M 205,560Net Total (assuming option exercised): (193 x 500,000) = M 96,500,000 + M 205,560 – 573,673 (premium) = M 96,131,887.
This is the method they used in the answer section. I’ve seen it in another question as well.
Can I not apply this method to your question (example 3) on opentuition?Fyi – This question (Gogarth) did not provide a spot rate on the date of transaction (31st Aug) – so I assume it wouldn’t even possible to use your method.
Am I missing something?Thank you
Can I ask why is converting at spot rate not sensible?
For instance if the management expects the home currency to weaken in the near future, is it not more beneficial if they convert the underhedged amount at spot rate?
(*if the forward rate is not given and we have to convert at spot rate)
ayalcohen: The amount over or under hedged is left at risk and converted at the spot rate on the date of the transaction. However, is there are forward rates given in the question, then this risk can be removed by using the forward rates on it. If there are no forward rates given (and no spot rate on the date of the transaction as is most likely always the case) then you cannot do any arithmetic on the over or under hedge, in which case you should just write briefly about the problem.
sohyh: If they were completely certain as to which way the exchange rate would move, then if it was going to move in their favour they would not need to any hedging at all.
The problem is that they are never going to be certain, and therefore not doing anything would mean that there would be risk in doing nothing and the whole object is to remove the risk.- Topics: 2
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Understood.
Going back to your example (example 3 in AFM notes) – if we ignore the over hedge due to lack of info etc then according to my calculations the Net total for Currency options exercised would be (22 x 31,250) = £687,500 + £5,556 (premium) = £693,056.
This leave a difference of around £10K from your Net total of £683,128.
Your method involved converting at spot (at trn date) = $1M/1.4100 = £709,220 (Pay)
Exercising option = (22 x 31,250) x (1.4750 – 1.4100) = $44,687.50/1.4120 = £31,648 (Rec)
Net Pay =(£709,220 – £31,648 + £5,556 (premium)) = £683,128I don’t understand why there are different methods and amounts for calculating Currency options hedge.
Will I lose marks for using my method?
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