UTS16657 Chap.13 Derivatives, Hedging and International Exposure
Derivatives, Hedging and International Exposure
Hedging means buying one exposure so that swings in wealth created somewhere else are insured against, and the instruments bought for that job are almost always derivatives, which take their value from the price of something underneath them.
Four limits are worth stating: hedging reduces uncertainty without eliminating all risk because the match is imperfect, it is not free because it involves a premium, it works only when the timing of the hedge matches the exposure period, and it may be partial or full.
In a forward contract the buyer and seller agree a price today and exchange the goods and cash at a future date, and any movement in between is irrelevant to the contract.
A futures contract is similar except that it trades on an organised exchange, which sets every element except the price itself. An option confers a right with no matching duty: a call lets its holder buy and a put lets its holder sell, in each case at a stated exercise price, exercisable on any date up to expiry if American and only at expiry if European.
A contract for difference is a leveraged bet on a price movement that does not grant ownership of the underlying, managed through four order types covering profit-taking, a loss limit, an absolute guaranteed floor and a stop that follows the price.
A swap exchanges payment obligations on the same principal on the principle of comparative advantage.
Going offshore has two motives: return enhancers seek a premium over the domestic market, and risk minimisers seek diversification away from a limited or inefficiently priced one.
Eight considerations frame the decision, covering the macroeconomic, legal, financing and tax environments, transparency, political issues, the exchange rate and emerging market risk.
Currency is where direction words are most often reversed. An appreciation of the domestic currency reduces the domestic value of a foreign receipt, because dividing a fixed foreign amount by a higher quotation gives a smaller number.
Exposure is managed by financial techniques such as hedging, insurance and changing leverage, or by real ones such as avoiding high-risk projects, and an international equity return therefore has three components rather than two.
What this chapter covers
- 01
What hedging buys, and the four limits on it
- 02
Forwards against futures, and what the exchange standardises
- 03
Calls, puts, exercise price, and American against European exercise
- 04
The payoff at expiry, and where the kink and break-even sit
- 05
Contracts for difference and the four risk-management orders
- 06
Cross-border motives and the eight considerations
- 07
The quotation convention, its drivers, and translating a foreign dividend
A call option settled at three different prices
- +1Total premium: 1.85 × 5,000 = $9,250 paid up front, which is the most that can be lost in any scenario.
- +1At $48.60 the option is in the money, since the exercise price sits below the market price. Gain per unit 48.60 − 42.00 = $6.60, gross 6.60 × 5,000 = $33,000, payoff 33,000 − 9,250 = +$23,750.
- +1At $43.20 it is still worth exercising and the trade still loses. Gross gain 1.20 × 5,000 = $6,000, payoff 6,000 − 9,250 = −$3,250. Exercising recovers part of the premium; not exercising would lose all of it.
- +1At $39.50 it is out of the money, so the holder buys in the market instead and loses the whole premium, −$9,250.
- +1Break-even: 42.00 + 1.85 = $43.85. Below it the position loses, above it the position gains a dollar for every dollar of price.
Key terms
- Forward contract
- An agreement to exchange goods and cash at a future date at a price agreed today, so any price movement between the contract date and the delivery date is irrelevant to the contract.
- Futures contract
- A forward that trades on an organised exchange, with every element of the contract determined by the exchange except the futures price, which the two parties set between them.
- Call option
- A contract giving the holder the right to buy a given underlying asset at the exercise price at any time before it expires. It is worth exercising once the exercise price sits below the market price.
- Put option
- A contract giving the holder the right to sell a given underlying asset at the exercise price on or before the stated expiry date. It is worth exercising once the exercise price sits above the market price.
- Contract for difference
- A leveraged position on the price movement of an instrument that does not grant ownership of the underlying, settled as the difference between the closing and opening prices.
- Trailing stop
- An order that follows a price in the favourable direction and closes the position automatically if it reverses, one of four tools the subject names for managing the downside on a margin trade.
- Return enhancer
- A cross-border investor seeking a premium over what the domestic market offers, as against a risk minimiser seeking diversification away from a limited or inefficiently priced home market.
- Currency risk
- The risk that revenues and expenses contracted in a foreign currency change in local-currency terms by the time they are actually settled and translated, which is one of the two main risks facing most Australian companies.
Derivatives, Hedging and International Exposure FAQ
When is a call exercised, and when is a put?
A call holder wants to buy below the market, so a call is worth exercising when the exercise price sits below the market price. A put holder wants to sell above the market, so a put is worth exercising when the exercise price sits above it. In both cases the decision compares those two prices only.
The premium does not enter the exercise decision because it has already been paid, and it enters only afterwards when you calculate whether the whole trade made money.
What happens to a foreign dividend when the domestic currency appreciates?
Its domestic value falls. A quotation of the Australian dollar against the United States dollar tells you how many United States dollars one Australian dollar buys, so translating a United States receipt means dividing by that quotation. An appreciation raises the quotation, and dividing a fixed foreign amount by a larger number gives a smaller answer.
A dividend of US$1,850,000 converts to A$2,794,562 at 0.6620 and only A$2,702,703 at 0.6845. The arithmetic itself is the check on the direction word.
How does a contract for difference differ from a futures contract?
Chiefly in ownership and flexibility. A futures contract has a predetermined date and price and the trader takes ownership of the underlying asset. A contract for difference does not grant ownership of the underlying instrument and can be bought or sold at any time or price.
The contract for difference is also more heavily leveraged, since option prices are much lower than the underlying, so the same margin opens a larger position, with correspondingly larger losses available.
Was a hedge wasted if the price moved favourably?
No, and the question misunderstands what was bought. A put gives a right rather than an obligation, so with the market above the exercise price the holder abandons the option and sells into the market at the higher price, losing only the premium against a larger revenue. What the premium purchased was a floor: had the price fallen, the holder would have received the exercise price regardless.
Judging a hedge by the outcome that happened rather than by the outcomes it protected against is the error, and it is the same error as calling insurance wasted because nothing burned down.
Exam move
Draw the two payoff profiles from memory with the kink at the exercise price and the break-even marked, because a diagram you can reproduce answers several question forms at once. Then rehearse the currency direction out loud, since it is the most frequently reversed word in the subject and the mechanical check is simply that dividing by a larger number gives a smaller answer.
The cross-border considerations are a list and can be revised last.
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