Alireza Arabi aai student. Simple foreign currency option hedge strategies,. A comparison of option contracts versus forward contracts. The use of currency options has been grown widely during the latest. This paper tries to answer whether hedge strategies using. To answer this question a model was decided to c ompare payoff of a. Conclusion is that comparing a single call or put o ption with single l.
Currency options, forward exchange rate, option hedging strategies. We are heartily thankful to our supervisor, Christos Papahristodoulou, whose encouragement,. Lastly, we offer our regards and blessings to all of those who supported us in any respect during.
Being students of analytical finance and going through courses like inv estment theory and. We came across hedging during our. The foreign currency market is claim ed to be one of the largest financial markets during the. A survey provided by Riksbank en 9 Octo ber, s hows that. As we were studying different books and articles we notice that options were not commonly.
Currency options were used mostly by giant companies while smaller companies. This was very s urprising, because in theo ry options comparing to. We started to wonder if. In this paper we wi ll approach two general targets; commerci al banks and medium size.
The market is an over the counter market. In this paper by the term bank w e mean major co mmercial banks which work w ith medium. A goo d exampl e can be Nordea and. The medium s ize companies or corporations, app roach the foreign. The Bank actually works as market representative for them.
For this reason a standardized ag reement is signed. The ag reement c ontains specifications for. It contains terms like the limits of the credit line ext ended to the company. They have currency desks working around the. In this paper w ith the term company we mean medium-sized Swedish businesses t hat trade. Their business involves several deals a month and banks are used when t he. These companies unde rstand the risk of foreign. The choice of strategy will depend on the type of business activity.
The hedge purposes, for this type of. Companies would typically t rade. They often deal with several. In Sweden usually currency derivative trades are over the counter deals. A deal between a. A financia l officer. The banks representative contacts his local tr ading d esk and normally gets the. If it is an uncommon currency then the local trade desk might have to make.
They will get the p rice according to cu rrent market levels. Sometimes there might be. If t hey are dealing with a forward contract, th ey will talk about spread. Normally t he spread for a small euro.
The larger the contract, the thinner is the spread. If they are dealing with. The reason behind this will become clearer in. We have to reca ll that. There are three types of contract used in foreign exchange market for trading foreign. Spot contract is an agreement for immediate sale and delivery of spot commodity s uch as. One side of the parties will be on a long position which means agrees to buy specified. Options are contracts that give the right to holder to b uy or sell an as set at the expiration.
The only obligation here is that to enter the contract, the investor or trader has. Options are classif ied into two bas ic t ypes, call opti ons an d p ut. Options are in two styles, European and American. Most of currency options are European. American option is not our i nterest here in this paper because they can be exercised any. Option contract can be traded on ex change traded markets which.
There is one clear benefit to an option contract hedge compared t o a forward contract. Options may be used in. Forwards protect the financial risk.
Commercial risk, is the risk that debtor will be unab le to pay. Options protect ag ainst the actual commercial risk, protecting the downside while retaining. For example if company X has to. But a competitor who uses an option hedge or do not hedge at all. As we found out that most companies other than giant ones rely on forwards to hedge their.
The di fference is the way they look at hedging and p urpose of their. Larger companies use derivatives to manage financial risk, while smaller companies use. The larger the fi rm the h igher degree of financial. The small companies or medi um size corporations are usually concern.
Their mai n aim is to avoid loss and they do not want to. Fo r them hedge is a cost and. This can explain very much why t hey often chose forwards as their hedging instrument,.
We ca n say the c ost of forward contracts is a hidden cost in the. Considering the s pread, size of a f orward contract. While in case of options it is very e asy to meas ure t he. Using the Futures, Forwards and Options Markets. Here comes another factor to be n oticed and that is risk.
Going back to the forward contract, the exact amount to be paid is. The amount to be paid. Thus to compare an o ption contract with a forward contract a total expected. Otherw ise forwards are risk free as they lock in a. In other words the standard. Therefore, it is better to consider total payo ff of both contracts for.
These set of questions and answers sets us towards our main problem, how would simple. In the introduction, we. We will try to. The third chapter contains. The ana lysis chapter is the analysis conducted and o ur. The final chapter we will contain the conclusion. The purpose of th is paper is to provide facts for ex panding of currency options. We ho pe by this simple strategy we can find facts to support our thinking that the.
In this part our goal is to provide and explain the t heories which are relevant to this paper in. Today international trade plays a big r ole in any e conomy.More...