Foreign Exchange Exposure

1
Foreign Exchange Exposure

• Cash flows of firm, ergo its market value, are
  affected by changes in the value of foreign
  currency, FX.
• Transactions Exposure Explicit contractual
  amount denominated in FX.
• Operating Exposure No contract exists yet FX
  exposure is present.

2
Two Methods of FX Quotation

• Direct Quotation
• Number of home (domestic, reference) currency
  units per unit of FX.
• Direct quote is inverse of indirect quote.
• Assumed in this course (intuitive).

• Indirect Quotation
• Number of FX units per unit of home (domestic,
  reference) currency.
• Indirect quote is inverse of direct quote.
• Not employed in this course (less intuitive).

3
Examples of Two Quotation Methods

• For Canadian firm.
• Direct quote on greenback, US C1.35
• Indirect quote on greenback US US0.74
• If FX appreciates (rises in value), the direct
  quote rises and the indirect quote falls.
• If FX depreciates (drops in value), the direct
  quote drops and the indirect quote rises.

4
Transactions Exposure

• First part of this four part course.
• Exporter - receives a contractually set amount of
  FX in future.
• Importer pays a contractually set amount of FX
  in the future.
• Measure of FX exposure the amount of FX
  involved.

5
Exporters Transactions Exposure

• Canadian beef exporter will receive US1 million
  3 months from now.
• S direct quote on the greenback, i.e. C/US, 3
  months hence. (Note / means per.) S is plotted
  on horizontal axis.
• Exposed cash flow (ECF) S x US 1 million. ECF
  is plotted on vertical axis.

6
Exporters Risk Profile
US1million
ECF(C)
S(C/US)
7
Exporters Risk Exposure

• Worried about depreciation in FX.
• Forward hedge Sell FX forward. Arrange now to
  sell 3 months hence at price determined now, F
  (the forward rate).
• Option hedge Buy right to sell FX, a put option
  on the FX.

8
Sell Forward Hedge

• Commit now to sell U 1 million 3 months from now
  at forward price, F, determined now.
• Price paid for Forward Contract zero.
• Sell forward contract cash flow (F S) x U 1
  million where S is the spot rate 3 months hence.

9
Sell Forward Contract
Contract Cash Flow
S(C/U)
F(C/US)
10
Hedge with Forward Contract
Hedged Cash Flow
F x U1million
S(C/U)
11
Hedge with Put Option

• Put option is the right, not obligation like
  forward contract, to sell U 1 million 3 months
  hence at an exercise or strike price of X(C/US).
• P, put premium, price paid now for option.
• Put contract cash flow X S if SltX 0
  otherwise.

12
Put Contract Cash Flow
S
X
13
Hedge with Put Option
Hedged Cash Flow
S
X
14
Which is better? Sell forward or Buy put?
B breakeven point SltB, sell forward better SgtB,
buy put better
B
S
15
Determination of B, breakeven FX Rate

• B is point of indifference between sell forward
  and buy put as hedges.
• SltB Forward is better ex-post
• SgtB Put is better ex-post
• B Forward rate Future Value of Put Premium
  where interest rate is hedgers borrowing rate.
• B F FV(P).

16
Hedging a U Receivable

• Canadian firm with U receivable due 6 months
  hence
• F (6 month forward rate) C 1.35
• X (exercise price) C1.32
• P (put premium per U) C0.05
• Borrowing rate 6 quoted APR
• B (breakeven) C1.4015

17
3 Different Interest Rate Quotes

• Borrow 1 for 6 months at 6
• APR, annual percentage rate, FV 1.03 1 (1
  .06/2 )
• EAR, effective annual rate, FV 1.02956 1 (1
  .06).5
• CC, continuously compounded, FV 1.03045 1
  exp(.06 x .5)

18
Canadian Importer Problem

• Has U 5 M payable due 6 months hence.
• Two possible hedges buy U forward or buy call
  on U.
• Buy forward Arrange now to buy U5M 6 months
  from now at a rate set now, F.
• Buy call on U 5 M with exercise price X.

19
FX Payable

• Worried about the FX appreciating

Exposed Cash Flow
S
-U 5 M
20
Buy U Forward Contract Cash Flow
U5M
S
F
21
Buy Call on U Contract Cash Flow
U5M
S
X
22
Hedged Cash Flows
X
B
S
Call Hedge
Forward Hedge
-F x U5M
23
B, breakeven FX rate between call and buy forward
hedges

• B forward rate - FV of call option premium
• FV (future value) uses the hedgers borrowing
  rate.
• SltB call option better ex-post.
• SgtB buy forward better ex-post.

24
Buy forward versus buy call
Contract Cash Flows
B
S
25
Calculation of B

• Canadian firm with U 5 M payable due 6 months
  hence.
• F C1.35 ( 6 month forward rate)
• X C1.32 (exercise price of call)
• C C0.10 (call premium per U)
• Borrowing rate 6 quoted CC
• B C1.247

26
Forward vs. Option Hedges Fundamental Trade-off

• Forward no up-front outlay (at inception value
  of forward 0) but potential opportunity cost
  later.

• Option up-front outlay (option premium) but no
  opportunity cost later, ignoring option premium.

27
Option hedge vs. Forward hedge vs. Remain exposed

• Hedge FX liability.
• Ex-post analysis S gt F, buy forward is best S lt
  F, remain exposed is best.
• Option hedge is never best ex-post.
• Option hedge is an intermediate tactic, between
  extremes of buy forward and remain exposed.

28
Option hedge vs. Forward hedge vs. Remain exposed
F
Remain exposed
29
Writing options as hedges

• Zero sum game between buyer and writer.
• Writers diagram is mirror image of buyers about
  X-axis.
• Writer receives premium income.
• Write call to hedge a receivable, I.e., covered
  call writing.
• Write put to hedge a payable.

30
Basic problem with writing options as a hedge

• Viable if there is no significant adverse move in
  FX rate.
• FX receivable viable if FX rate does not drop
  significantly.
• FX payable viable is FX rate does not rise
  significantly.
• The original exposure remains albeit cushioned by
  the receipt of premium income.

31
A Lego set for FX hedging

• Six basic building blocks available for more
  complex hedges.
• Buy or sell forward.
• Buy or write a call.
• Buy or write a put.

32
Application of Lego set

• Option collar is an option portfolio comprised of
  long (short) call and short (long) put.
  Maturities are common but exercise prices may
  differ.
• What if there is a common exercise price F, the
  forward rate pertaining to the common maturity of
  the options?
• Value of option collar must zero.
• Option collar replicates forward contract.

33
Option collar (buy call, sell put common X F)
or Buy Forward
S
F
34
F defines a critical value of X

• Another application of Lego set, option collars,
  and graphical reasoning.
• If X F, C (call premium) P (put premium).
• If Xlt F, C gt P.
• If Xgt F, C lt P.

35
Salomons Range Forward

• Another application of Lego set.
• See Transactions Exposure Cases Salomon Contract
  to Aid in Hedging Currency Exposure.
• Buying a Range Forward is an option collar where
  a call, with X upper limit of range, is
  purchased and a put, with X lower limit of
  range, is written.

36
Salomons Range Forward (specific numbers)

• F 1/DM 2.58 U0.3876
• Range Upper limit, U 1/DM2.50 U0.40
• Range Lower limit, L 1/DM2.65 U0.3774
• If S(U/DM) gt U0.40, US client buys DM at
  U0.40.
• If S lt U0.3774, US client buys DM at U0.3774.
• If U0.3774 lt S ltU0.40, US buys DM at S.

37
Salomons Range Forward
Contract Cash Flow
L0.3774
U0.4
S
38
Salomons Range Forward
FX Liability Hedged Cash Flow
L
U
S
39
To alternative ways of committing to buy (sell)
FX in future

• Futures Contract
• Traded anonymously on an exchange.
• Marking to market there are daily cash flow
  experienced.
• Assume futures rate forward rate.

• Forward Contract
• Deal directly with bank.
• No cash flows until maturity
• Empirical result For FX, futures rate forward
  rate on average.

40
Conditional (contingent) exposure

• Whether or not you are exposed to the
  contractually specified FX depends on someone
  elses decision.
• Situation where an option should be used, not a
  forward.
• Examples cross-border merger, bidding on a
  foreign construction contract, selling with a
  dual currency price list.

41
Telus Case

• Dual currency prices C1,682 or Bh32,799.
• Customer decides on currency.
• Hedging the time span between sale and customers
  currency decision must be with a put option, not
  sell forward.
• Defined implied spot rate, S C0.051
  C1,682/Bh32,799.

42
Telus Risk Exposure
C1,682
S(C/Bh)
C0.051
43
Effect of dual currency prices

• Client chooses to pay currency adjusted amount.
• As if the following were true Telus demands
  payment in Cs but gives client a put option on
  Bh.
• Since Telus issues a put option to the client, it
  must buy the same option to hedge.

44
Danger in hedging conditional exposure with a
forward

• Problem if Telus were to sell Bh forward Telus
  may not receive Bhs.
• Client will choose to pay in Cs if the Bh
  appreciates beyond C0.051.
• If Bh appreciates, Telus must satisfy the forward
  contract by buying the appreciated Bh on the spot
  market.

45
Telus hedged diagram if sell forward at F
C0.051
C1,682
Telus faces unlimited losses
C0.051
46
Linkage between forward and options

• Forward contract is an option collar.
• Buy forward buy call, sell put with X F.
• Sell forward sell call, buy put with X F.
• Value of option collar 0.
• What if X not F?
• Put-Call-Forward Parity Theorem

47
Put Call Forward Parity (graph)
S
X
F
48
Put Call Forward Parity

• C, P Call and Put premiums
• R domestic risk-free rate

49
Put-Call Forward Parity Example

• 1-year contracts on sterling, PS.
• F C2.50 X C2.40 T 1 year
• R (riskless Canadian rate) 5 quoted CC
• Via equation, C-P C0.095
• If P C0.05 then C C0.145.
• If C C0.20 then P C0.105.

50
Value of buy forward contract post inception
Fs are forward rates, N new versus O
original. R is domestic risk-free rate, T
remaining maturity of forward at new
date. Another interpretation FN is prevailing
forward rate Fo is desired contractual rate.
51
Value of buy forward post inception
FO
FN
52
Post inception buy forward example

• Bought 13-month sterling forward a month ago at
  then prevailing forward rate, F13 C2.40.
• Now prevailing F12 C2.50 T 1year R
  (riskless Canadian rate) 5 CC.
• Value of Forward contract now C0.095 versus at
  contract inception of 0.

53
Contractual F vs. Prevailing F

• Contract. F that specified in the contract
• Prevail. F that which renders the value of the
  contract zero.
• Heretofore Contract. F Prevail. F ergo no
  money changes hands at inception
• If contract. F not prevail. F, money changes
  hands at inception
• Who pays whom? How much is paid?

54
2nd interpretation Buy PS 1-year forward

• Prevail. F C2.50 per PS
• Contract. F C2.40 per PS
• Canadian interest rate 5 CC
• Firm must pay bank upfront 0.095 per PS
• The same formula has a different interpretation!

55
Value of sell forward post inception
New versus original forward rates
T time remaining until contract expiration at
new date R domestic risk-free rate Another
interpretation FN is prevailing forward rate Fo
is desired contractual rate.
56
Value of sell forward post inception
S
FO
FN
57
Post inception sell forward example

• Sold13-month sterling forward a month ago at then
  prevailing forward rate, F13 C2.40.
• Now prevailing F12 C2.50 T 1year R
  (riskless Canadian rate) 5 CC.
• Value of Forward contract now - C0.095 versus
  at contract inception of 0.

58
2nd interpretation Sell PS 1-year forward

• Prevail. F C2.50 per PS
• Contract. F C2.40 per PS
• Canadian interest rate 5 CC
• Firm must pay bank C0.095 per PS upfront, i.e.
  bank must pay firm C0.095 per PS upfront.
• The same formula has a different interpretation!

59
Coberturas Mexicanas

• Forward contract on greenbacks denominated in
  Mexican pesos.
• Price fixed in the contract is not the prevailing
  forward rate but the spot rate, So, at the
  contracts inception.
• Since usually FgtSo, an up-front fee, of
  PV(_at_Rm)(F-So) is imposed for compra de cobertura
  (buy) contract.

60
Compra de Cobertura (example)

• Buy U1,000 9-month cobertura.
• F (9-month) MP10.
• So (at contract inception) MP9.70.
• Mexican riskless rate (CETES) 15EAR.
• Up-front fee payable by firm to bank MP270 PV
  of U1000 x (10-9.7).

61
Venta de Cobertura (example)

• Sell U1,000 9-month cobertura.
• F (9-month) MP10.
• So (at contract inception) MP9.70.
• Mexican riskless rate (CETES) 15EAR.
• Up-front fee receivable by firm from bank MP270
  PV of U1000 x (10-9.7).

62
Derivatives Pricing Problem

• Case in Transactions Exposure.
• Customer wants to sell DM125,000 5-month forward
  at rate of U0.36 when prevailing forward is
  U0.353.
• What price to charge customer? U848.
• Price U(0.36-0.353)x125,000xPVfactor.
• Riskless rate,7.5, is appropriate.

63
Derivatives Pricing Problem

• Customer also wants to buy a put on 125,000 DMs
  5 month maturity.
• Price of call with identical terms, C U0.01 x
  125,000 U1,250
• Option collar (P-C), replicates previous forward
  contract.
• P U1,250 U848. Thus, P U2,098.

64
FX Bid-Ask Spread

• Bank is willing to buy FX at Bid.
• Bank is willing to sell at (is asking) Ask.
• Terms adopt banks perspective.
• Hedging firm must buy FX at higher Ask and sell
  FX at low Bid.
• Buying one currency means selling the other
  currency. Implies Bid in one currency is the Ask
  of the other currency.

65
FX Bid-Ask Spread (transactions cost)

• round trip cost (1-(bid/ask)).
• Bid on U C1.48 Ask C1.51.
• Implies Bid on C 1/C1.51 Ask 1/C1.48.
• (1 (1.48/1.51) ) 2 (C1,000-C980.13)/C1,0
  00.
• C1,000 to U662.25 (C1,000/C1.51)to C980.13
  (U662.25xC1.48).

66
Case Options Trip Hiro Goto

• Japanese exporter wanted to hedge U10M
  receivable via a put option.
• Finance put premium by issuing a call.
• 3CP CltP as FltXJY125/U I.e., market expecting
  U to drop below JY125.
• Zero cost option hedge is an option collar with a
  twist due to different contractual amounts.

67
Hiros Hedge Options Collar
Buy put on U10M
S(JY/U)
JY125
Sell call on U30M
68
Hiros Hedged Cash Flow
125
135
What eventuated!
69
Gomenasai! (Sooo sorry!)

• What Japanese exporter learned By setting up an
  option collar, the up-front hedging outlay was
  reduced to zero, but the potential for a
  down-the-road opportunity cost was created.
• The potential opportunity cost eventuated! Pity!
• Hiro insidiously shifted from an option hedge to
  a type of forward hedge.

70
Black-Scholes Model for Valuing FX Options

• Applies only to European, not American, type.
• Forward rate version employs forward rate with
  maturity same as that of option.
• Spot rate version employs spot rate at time
  option is purchased. Also, foreign risk-free
  rate.
• Variables common to both models X, exercise
  price T, time to expiry RD, domestic risk-free
  rate volatility (standard deviation) of the
  continuously compounded rate of appreciation.

71
BS Model, Forward Rate Version

• C Call premium P Put premium

N(d2) probability call exercised N(-d2)
probability put exercised
72
Use numa.com calculator to implement Forward Rate
Model

• Under calculators click options
• Stock price Forward rate
• Interest rate and Dividend yield both Domestic
  risk-free rate.
• Exercise price, Time to expiry, and Volatility
  defined as given.

73
Forward rate model example

• Value a call option on SFR (South African Rand) 1
  M with X C0.65, 1-year F C0.70, Canadian
  risk-free rate 10 CC, and volatility (standard
  deviation) 24.8.
• Numa.com value, C C84,000.
• By selling SFR forward now can lock-in future
  profit of 50,000 (.70 - .65) 1M

74
BS Model, Spot Rate Version

• C Call premium P Put premium

RF foreign risk-free rate, plays role of
dividend-yield of stock on which stock option is
written.
75
Use numa.com calculator to implement Spot Rate
Model

• Under calculators click options
• Stock price Spot rate
• Interest rate Domestic risk-free rate Dividend
  yield Foreign risk-free rate.
• Exercise price, Time to expiry, and Volatility
  defined as given.

76
Spot rate model example

• Value a call option on SFR (South African Rand) 1
  M with X C0.65, S C0.68, Canadian risk-free
  rate 10 CC, SFR risk-free rate 7 CC and
  volatility (standard deviation) 24.8.
• Numa.com value, C C84,000.
• Both BS models yield same value iff interest rate
  parity (to be discussed) holds.

77
Adjusting for BS in the BS model (or applying the
model to the real world)

• BS model assumes no transactions costs (no
  bid-ask spread).
• Thus, use average of bid and ask rates as the FX
  rate. This applies to both spot and forward
  rates.
• BS model assumes ability to borrow and lend at
  the same interest rate.
• Thus, use average of deposit and borrowing rates
  as the interest rate. This applies to both
  domestic and foreign interest rates.

78
Interest Rate Parity Theorem

• Based on financial arbitrage.
• Assume 1 year period.
• Domestic investment/financing (1RD).
• Forward hedged foreign investment/financing
  (1RF)(F/S).
• Equality must hold.

79
Interest Rate Parity Formulas
80
Interest Rate Parity Intuition

• IRP a statement about what holds in equilibrium.
• A high interest rate currency, FX, trades at a
  forward discount. Why? Otherwise, if it traded
  at a forward premium it would be an attractive
  investment for everyone.
• A low interest rate currency trades at a forward
  premium. Why? Otherwise, if it traded at a
  forward discount it would be an attractive
  financing venue for everyone.

81
Interest Rate Parity Numerical Example

• Current spot rate on greenback C1.35
• 2-year forward rate on greenback C1.41 (this
  is usually the unknown)
• R canadian 7 CC
• R u.s. 5 CC
• Greenback trades at a forward premium because it
  is the low interest rate currency.

82
Interest Rate Parity How many variables?

• How many variables do you see?
• In reality, 8 not 4!
• Domestic borrowing, deposit rates.
• Foreign borrowing, deposit rates.
• Bid, ask spread on spot.
• Bid, ask spread on forward.

83
Money market hedging

• Application of interest rate parity theorem.
• Synthesize a forward contract with 3
  transactions buy (sell) FX in spot borrow(lend)
  in domestic currency lend(borrow) in FX.
• Why? May be able to enhance cash flows compared
  with outright forward contract.

84
Enhance cash flows?

• If have an FX liability, may be able to buy FX at
  a lower rate than F, I.e., decrease outlays.
• If have an FX receivable, may be able to sell FX
  at higher rate than F, I.e. increase inflows.
• FX liability Borrow domestic, buy FX spot,
  invest foreign synthesizes buy outright forward.
• FX receivable Borrow foreign, sell FX spot,
  invest domestic synthesizes sell outright
  forward.

85
MMH 2 complementary interpretations

• Create an offsetting FX cash flow if FX
  receivable, create FX outflow if FX payable,
  create FX inflow.
• Advance FX transaction date instead of forward
  transaction, perform spot transaction now.

86
Money market hedge numerical example

• Canadian firm will receive U1M 6 months from
  now.
• S bid C1.38 F bid (6 months) C1.39.
• U borrowing rate 8 APR
• Canadian deposit rate 10 APR
• If use outright forward will receive C1.39 6
  months hence. Can you enhance this?

87
Is a money market hedge better?

• Borrow U1M/1.04 U0.9615M
• Sell Us in spot, receive C1.3269M
• Invest Cs at C deposit rate, receive after 6
  months C1.3269M x 1.05 C1.3933M
• Payoff U loan U0.9615 x 1.04 U1M with
  projected receivable. Note U loan principal
  designed to achieve this.
• Money market hedge superior by C3,300.

88
Money market hedge FX liability

• Canadian firm has a liability of PS(sterling)1M
  due a year hence.
• F ask (1 year) C2.40 S ask C2.30.
• Canadian borrowing rate7 APR or EAR
• UK deposit rate4 APR or EAR
• Which is better? Buy outright forward or
  construct a money market hedge?

89
Buy forward or MMH?

• If buy PS forward (outright), pay C2.4M a year
  hence.
• If construct money market hedge, pay synthesized
  forward rate, FMMH C2.37 per PS or C2.37M a
  year hence.
• Save C30,000 by constructing MMH.
• MMH steps borrow C, buy PS spot, invest PS.

90
MMH transactions FX liability

• Now Borrow (2.3)PS1M/1.04C2.21M
• Buy PS spot C2.21/2.3PS.96M
• Invest PS at 4
• After 1 year Close out PS deposit, obtain
  PS.96(1.04)PS1M this is used to meet liability.
• Pay off C loan, i.e., C2.21M(1.07) C2.37M
  PS1M(FMMH)

91
Option collar as synthetic forward

• Same exercise price for both put and call.
• Buy put sell call synthesizes sell forward.
• Sell put buy call synthesizes buy forward.
• Foc synthetic forward rate
• Apply buy low sell high rule.
• Hedge FX receivable higher is better.
• Hedge FX payable lower is better.

92
Forward rate synthesized with option collar

• C, P call, put premiums with common X.
• FV future value using domestic rate borrowing
  (if initial cash flow negative) or deposit (if
  initial cash flow positive).

93
FV calculation

• Initial CF lt 0, use borrowing rate
• Initial CF gt 0, use deposit rate
• Rationale Same logic that applies to the use of
  WACC in investment appraisal (vide course
  prerequisite)
• Notwithstanding that, in a specific year, may
  have abundant unused bank-borrowing capacity to
  finance project, must use WACC
• Calculation procedures applied as long-term policy

94
Sell outright forward or option collar?

• Canadian with U1M receivable due 6 months hence.
• Canadian deposit rate 7 APR
• 6-month forward rate on U C1.39
• XC1.37 Per U P C0.09, C C0.14
• FocC1.42 ergo rather than sell outright
  forward, Foc it!

95
Option collar transactions now

• Buy put, -C0.09M
• Sell call, C0.14M
• Invest initial net cash flow of C0.05M in bank
  account, -C0.05M
• Note If initial net cash flow is lt 0, must
  finance it. Ergo, use borrowing rate.

96
Option collar cash flows after 6 months

• Receive exercise price, C1.37M, for sure either
  exercise put or the call gets exercised against
  you (Canadian firm).
• Deliver U1M with projected receipt
• Close out bank account, receive C0.05Mx(1.035)
  C0.05175M
• Net CF C1.42M gt Foutright C1.39M

97
Hedging Protocol

• Determine best forward hedge outright, MMH, or
  OC.
• Put your best forward forward.
• Compare best forward hedge with option, I.e.,
  calculate B breakeven rate.
• Example case Yo quiero Taco Bell!

98
2nd Generation FX Options

• Designed to reduce up-front hedging cost
• 1. Asian- underlying variable is not spot rate at
  a point in time in future by average spot rate
  over an interval of time.
• 2. Barrier- barrier must be crossed for the
  option to be created or cancelled.
• 3. Compound- option on an option or option
  conditional on some event.

99
Asian Options

• Appropriate for a firm that receives or pays a
  continuous stream of FX cash flows.
• E.g., firm receives an amount of FX monthly. How
  to hedge for one year?
• 1. Twelve put options on the FX or
• 2. One Asian put for the entire year.
• Note lower volatility ergo lower premium, i.e.,
  hedge 2 is cheaper.

100
Pros Cons of Asian put hedge

• Pro cheaper due to lower volatility of
  underlying asset. Reason law of large numbers.
• Con the risk you are hedging against is not
  quite the same as the risk to which you are
  exposed. E.g. at end of Jan, you are exposed to
  SJan, but you hedge against risk of SAverage.

101
Why are Asian options European?

• Asian options payoff depends on average spot
  rate during options life
• Must arrive at expiration date of option to
  determine average spot rate
• Cannot determine payoff until expiration date
• Asian options are not American

102
Barrier Options

• New parameter B, the barrier, is defined.
• If B is crossed (spot rate B), the option is
  either created or cancelled automatically.
  Creation/Cancellation occurs only once during
  life of option.
• Premium is lower than traditional option.
• Why? Option may not exist initially or option may
  be prematurely cancelled.

103
Barrier Options

• Up vs. down Will FX rate, S, rise or fall to
  barrier? Up So lt B Down So gt B.
• In vs. out Will the FX option be automatically
  created or cancelled?
• Put vs. call?
• Total of 8 types but only 2 are viable hedges.
• Down out puts, up out calls do not make
  sense. Why? Option is cancelled precisely when
  you need it!

104
Barrier Puts

• B lt So Down in created when needed Down
  out cancelled when needed.
• So lt B Up in created when not needed Up
  Out cancelled when not needed but exposure to
  zig-zag behavior remains.
• Conclusion only Down In Puts make sense from a
  hedging perspective. Outs are out!

105
Hedging FX receivable with a barrier put

• Down in puts are viable.
• Lower premium compared to standard put.
• Beware Up out puts! Why? Exposure to zig-zag
  behavior in FX rate.
• If FX rate rises past barrier, the Up out put
  is canceled. If FX rate then drops, youre
  exposed!

106
Barrier Calls

• B lt So Down in created when not needed Down
  out cancelled when not needed but exposure to
  zig-zag behavior remains.
• So lt B Up in created when needed Up out
  cancelled when needed.
• Conclusion only Up in Calls may sense from a
  hedging perspective. Outs are out!

107
Why are out barrier options not suitable for
hedging an FX liability?

• Up out call hedge is cancelled precisely when
  needed.
• Down out call exposure to zig-zag behaviour in
  the spot rate remains, i.e., rate drops, call is
  cancelled, then rate rises.

108
Hedging FX payable with a barrier call

• Up in calls are viable.
• Lower premium compared to standard call.
• Beware Down out calls! Why? Exposure to zig-zag
  behavior in FX rate.
• If FX rate drops below the barrier, the call is
  cancelled. If FX rate then rises, you are
  exposed!

109
Compound Options

• Option on an option call on call (for FX
  liability) or call on put (for FX receivable).
• Event-contingent options option is created only
  if event occurs. Cross-border tender offer use
  takeover contingent FX call. Bid on foreign
  project use FX put contingent on bid winning.
• Lower up front premium.

110
What compound options are appropriate hedges?

• Situation submit a bid to construct expressway
  in Djakarta (Indonesia).
• Buy call on a put on the Rupiah
• Buy event-contingent put on the Rupiah where
  event is defined as your winning the contract.

111
Why are premiums lower for the two compound
options?

• Call on a put has lower value than the underlying
  put.
• Premium on bid-contingent put is approximated by
  the following product (premium on traditional
  put) X (probability of winning the bid).