Options market Hedge Options provide a flexible hedge against the downside, while preserving the upside potential To hedge a foreign currency payable buy calls on the currency If the currency appreciates, your call option lets you buy the currency at the exercise price of the call To hedge a foreign currency receivable buy puts on the currency If the currency depreciates, your put option lets you sell the currency for the exercise price McGraw-Hilylrwoin 13-10 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 13-10 Options Market Hedge ⚫ Options provide a flexible hedge against the downside, while preserving the upside potential. ⚫ To hedge a foreign currency payable buy calls on the currency. ◼ If the currency appreciates, your call option lets you buy the currency at the exercise price of the call. ⚫ To hedge a foreign currency receivable buy puts on the currency. ◼ If the currency depreciates, your put option lets you sell the currency for the exercise price
Cross-Hedging Minor Currency Exposure o The major currencies are the: U.S. dollar Canadian dollar, British pound, French franc Swiss franc, Mexican peso, Italian lira, German mark. Japanese yen and now the euro o Everything else is a minor currency. like the P olish zIo It is difficult, expensive, or impossible to use financial contracts to hedge exposure to minor currencies McGraw-Hilylrwoin 13-11 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 13-11 Cross-Hedging Minor Currency Exposure ⚫ The major currencies are the: U.S. dollar, Canadian dollar, British pound, French franc, Swiss franc, Mexican peso, Italian lira, German mark, Japanese yen, and now the euro. ⚫ Everything else is a minor currency, like the Polish zloty. ⚫ It is difficult, expensive, or impossible to use financial contracts to hedge exposure to minor currencies
Cross-Hedging Minor Currency Exposure o Cross-Hedging involves hedging a position in one asset by taking a position in another asset The effectiveness of cross-hedging depends upon how well the assets are correlated An example would be a u.s. importer with liabilities in Czech koruna hedging with long or short forward contracts on the euro. If the koruna is expensive when the euro is expensive, or even if the koruna is cheap when the euro is expensive it can be a good hedge. But they need to co-vary in a predictable way McGraw-Hilylrwoin 13-12 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 13-12 Cross-Hedging Minor Currency Exposure ⚫ Cross-Hedging involves hedging a position in one asset by taking a position in another asset. ⚫ The effectiveness of cross-hedging depends upon how well the assets are correlated. ◼ An example would be a U.S. importer with liabilities in Czech koruna hedging with long or short forward contracts on the euro. If the koruna is expensive when the euro is expensive, or even if the koruna is cheap when the euro is expensive it can be a good hedge. But they need to co-vary in a predictable way
Hedging Contingent Exposure If only certain contingencies give rise to exposure, then options can be effective insurance For example, if your firm is bidding on a hydroelectric dam project in Canada, you will need to hedge the Canadian-US dollar exchange rate only if your bid wins the contract. Your firm can hedge this contingent risk with options McGraw-Hilylrwoin 13-13 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 13-13 Hedging Contingent Exposure ⚫ If only certain contingencies give rise to exposure, then options can be effective insurance. ⚫ For example, if your firm is bidding on a hydroelectric dam project in Canada, you will need to hedge the Canadian-U.S. dollar exchange rate only if your bid wins the contract. Your firm can hedge this contingent risk with options
Hedging recurrent Exposure with Swaps e Recall that swap contracts can be viewed as a portfolio of forward contracts Firms that have recurrent exposure can very likely hedge their exchange risk at a lower cost with swaps than with a program of hedging each exposure as it comes along It is also the case that swaps are available in longer-terms than futures and forwards McGraw-Hilylrwoin 13-14 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 13-14 Hedging Recurrent Exposure with Swaps ⚫ Recall that swap contracts can be viewed as a portfolio of forward contracts. ⚫ Firms that have recurrent exposure can very likely hedge their exchange risk at a lower cost with swaps than with a program of hedging each exposure as it comes along. ⚫ It is also the case that swaps are available in longer-terms than futures and forwards