Risk Management in Futures & Options - To Hedge or Not To Hedge??

To hedge or not to hedge?

• Hedging = risk mitigation by using forward contract, futures and option.
• Against Hedging: costly, difficult, not suitable for risk-averse investors, and can create bad incentives (attempt for currency speculations).
• For Hedging: can reduce firm's expected taxes (tax-loss carry forward & convex tax code), lower the costs of financial distress, improve firm's future investment decisions. --> If firm did not hedge and its value fell, (+) NPV projects may be missed. 

Futures Contract

• Allow individuals and firms to buy and sell specific amounts of foreign currency at an agreed-upon price determined on a given future day.
• Differences between forward contract and futures contract:
• Futures: traded on an exchange (NYSE, Tokyo Financial Exchange), forward: made by bank and their clients.
• Futures: standardised smaller amounts of currencies, forward: larger.
• Futures: have only a few maturity dates, fixed and generally 6 month. Forward: a client can request any future maturity date with maturities of 30, 60, 90, 180 or 360 days.
• Credit risk --> 
• Forward contract: Bank willingly trade it with large corporations, hedge funds, and institutional investors. But not trade with individual investors or small firm with bad credit risk.
• Futures: all contracts are between a member of the exchange and the exchange itself. Retail clients buy it from futures brokerage which must be registered with CFTC (Commodity Futures Trading Commissions) as FCM (Futures Commissions Merchant). Clearing member/clearinghouse.
• Margins
• Credit risk is handled by setting up an account called a margin account --> deposit an asset to act as collateral.
• 1st asset --> initial margin
• Asset can be cash, US government obligation, securities, gold or letter of credit.
• Marking to market --> deposit of daily losses/profits
• Maintenance margin --> minimum amount that must be kept to guard against severe fluctuations in the futures price.
• Margin Call --> when the value of the margin account reaches the maintenance margin. --> the account must be brought up to its initial value.
• Pricing:
• Payoff on forward contract --> S(t) - F(t) ; S(t): future spot rate, F(t): forward price
• Payoff on futures contract  -->  f(T) - f(t) ; f(T): futures price at maturity time, f(t): futures price 
• Potential problems with Futures Contract:
• Futures contracts are sold only in standardised sizes (ex: $125,000). Problem: if you need to hedge an amount that is not a multiple of the standard size.
• Relative low number of delivery date, which sometimes the maturity date of futures contract not match with a settlement date of the company's asset and liabilities.
• Basis risk: if the price of futures contract does not move one-for-one with the spot exchange rate (not perfectly hedge). The basis is the differences between the spot price at time t, S(t), and the futures price at time t, f(t,T), for maturity date at time T.

Foreign Currency Option Contract

• Gives the buyer the right, but not the obligation to buy (call) or sell (put) a specific amount of foreign currency for domestic currency at a specific forex rate.
• Price is called premium.
• Traded by money centre banks and exchanges (e.g. NASDAX OMX PHLX)
• European vs American option: European --> exercise only at maturity date; American --> exercise any time.
• Strike/exercise price --> forex rate in the contract, compare with the current spot exchange rate. 
• Intrinsic value --> revenue from exercising an option
• in the money: if some revenue could be earned by exercising the option immediately.
• out of the money: no revenue
• at the money: option has a strike price equal to the current spot rate.
• at the money forward: option has a strike price equal to the forward rate for that maturity.

Exchange-listed currency warrants

• Longer maturity foreign currency options (> 1 year)
• Issued by major corporations.
• Actively traded on exchanges such as the American Stock Exchange, London Stock Exchange, or ASX.
• American-style option contracts
• Allow retail investors and small corporations which is too small to participate in OTC market to purchase L/T currency options.

Synthetic forward contract: Using put and call options (same K) simultaneously --> Ex: purchase a $ put option and write a $ call option for revenue. Both are at strike price K.

Combination of Options and Exotic option:

• Exotic options: options with different pay-off patterns than the basic options.
• Range forward contract:  allows a company to specify a range of future spot rates over which the firm can sell or buy forex at the future spot rate --> no money up front.
• Cylinder options: allow buyers to specify a desired trading range and either pay money or potentially receive money up front for entering into the contract.
• Both can be synthesized: buying a call and selling a put (at a lower K) and for range forward.
• Average-rate option: where S defined as the average forex rate between the initiation of the contract and the expiration date.
• Barrier options: regular options with additional requirement that either activates or extinguishes the option if a barrier forex is exchange.
• Lookback option: option that allows you to buy/sell at least/most expensive prices over a year (more expensive than regular options).
• Digital options ("binary" options): pays off principal if K is reached and 0 otherwise (think lottery). 

Forward Markets and Transaction Exchange Risk

Transaction exchange risk -- possibility of taking a loss in foreign exchange transactions. Normal distribution for major currencies, but skewed distribution for emerging markets.

Forward contracts -- forward rate (specified in a forward contract); eliminates risk/uncertainty; usually a large sum of money; with bank. Costs: ex ante (before), ex post (after).

Swap: simultaneously purchase and sale of a certain amount of foreign currency for two different dates in the future.

Volatility clustering: when standard deviations (volatility) in forex rate demonstrate a pattern. -- GARCH model.

Exchange Rate System

• Floating currencies: determined by the market forces of supply and demand; 
• managed floating: central banks intervene enough with the country's currencies; 
• fixed/pegged currencies: "pegging" (fix at particular level) a currency to another or a basket of currencies, often used a currency board (domestic currency 100% backed by assets payable in reserve currency; 
• target zone: forex rate is kept within band, the currency is allowed to fluctuate in a percentage band around a "central value".
• crawling pegs: changes are kept lower than preset limits that are adjusted regularly (w/ inflation), adjust for inflation differential between domestic inflation vs inflation of the pegged's currency so the domestic firm's don't lose competitiveness. Latent volatility: the true currency risk does not show up in day-to-day fluctuations, in a long time, historical volatility appears to be zero or very limited.
• special arrangements: where a regional central bank controls the forex rate system for several countries.

Central Banks: Liabilities -- monetary base or base money: deposits of financial institutions (bank reserves) and currency in circulations; Assets: official international reserves ( T-Bills of other countries, gold reserves, IMF-related reserve assets) and domestic credit (government bonds and loans to domestic financial institutions). Seigniorage: the value of the real resources that the central bank obtains through the creation of base money.

The imposible trinity (only two out of three are possible): perfect capital mobility (no capital control), fixed exchange rates, domestic monetary autonomy.

Central Bank interventions: money supply/interest rates, attempts to restrict capital movements, tax/subsidise international trade to influence demand for foreign currencies.

Foreign exchange interventions: Non-sterilised and sterilised (off-setting the effect of money supply by performing an open market operation that counteracts the effect: portfolio shifting on private investors--replace foreign bonds with domestic bonds; squeezing foreign inventories at dealer banks and generate pricing effects). Direct channel: small size - short term effect to sterilised interventions; Indirect channel: interventions can alter people expectations and affect their investments - push to the desire direction.

Defending the target zone: intervene through open market operations, raise interest rates, limits foreign exchange transactions through capital controls.

Lag operations: postpone capital inflow: receivable - exporter (especially when domestic currency devalued)

Lead operations: domestic importer prepay for goods in devaluations effect.

Dollarisation: foreign currency has exclusive or predominant status as full legal tender in a particular country (Ecuador: Dollar).