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Published on April 18, 2008

Author: Nivedi

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Synthetic Option Hedging:  Synthetic Option Hedging Synthetic Short Futures Hedge:  Synthetic Short Futures Hedge Synthetic Long Futures Hedge:  Synthetic Long Futures Hedge Synthetic Option vs Futures:  Synthetic Option vs Futures With a synthetic option you are paying two commissions to the broker, whereas with a futures hedge you pay only one commission. The trader is subject to margin calls with both a futures hedge and a synthetic hedge because he has sold an option. Most synthetic hedge do not offer any advantages over a traditional futures hedge. A simple variation of the synthetic short hedge is to buy a put and sell a call at different strike prices such that a positive premium is earned up front. Synthetic option hedging:  Synthetic option hedging How to creet short and long future hedge using options Advantages and disadvantages of synthetic option hedging. Synthetic option vs futures Price insurance Exotic Options:  Exotic Options Plain Vanilla vs Exotic Packages Non-standard American Options Bermuda options Compound options Chooser options Binary options Cash-or-nothing call Cash-or-nothing put Shout options Asian options Option Pricing Using Black-Scholes Model:  Option Pricing Using Black-Scholes Model Black’s Formula:  Black’s Formula The formulas for options on futures are known as Black’s formulas Estimating Volatility from Historical Data:  Estimating Volatility from Historical Data 1. Take observations S 0, S 1, . . . , Sn at intervals of t years 2. Define the continuously compounded return as: 3. Calculate the standard deviation of the ui ´s (=s*) 4. The volatility estimate (s) is Option vs Future Hedging:  Option vs Future Hedging Both can be used to protect against adverse price movement. Option hedging allows price movements in favor of the cash position to be captured. But future hedging prevents you from receiving the benefits of favorable price movements Practical Hedging Considerations:  Practical Hedging Considerations Types of Practical problems:  Types of Practical problems In this chapter, we will discuss about some practical problems that hedgers face. We have divided these problems into three sections. Hedging classification Cross hedging Selective hedging Cross Hedging:  Cross Hedging The major problem in hedging any commodity is that the cash position and the futures position do not match exactly. Most of the times, futures contracts do not fit cash position of the hedger. This nonalignment can take several forms Different commodities: The future contract is for one commodity and cash position or need is for another similar commodity. Example: Future contract is sold for #2 yellow corn and the cash position is sorghum or alfalfa. Problem of Different Quantity:  Problem of Different Quantity As indicated earlier, one of the most troublesome aspects of hedging is the issue of matching the size of the cash position and future position. Example: Cash position may be 63,000 pounds of fed cattle but the live cattle futures is for 40,000 pounds at CBOT and 20,000 pounds at Mid America Exchange. Can you hedge and if so, how much? Because of the inexact amounts of most cash positions, almost 100 percent of all hedges are either overhedged or underhedged. Problem of Different Quantity:  Problem of Different Quantity An overhedged occurs when the futures quantity exceeds the cash quantity. An underhedged occurs when the cash quantity exceeds the future quantity. The problem can be handled by trying to match quantities as closely as possible. Hedging Strategies: The Financials:  Hedging Strategies: The Financials Interest Rate Futures:  Interest Rate Futures In this chapter, we will be talking about interest rate futures contracts and hedging. Two concepts necessary for a good understanding of interest rate futures. Price/Rate Relationships Yield curves Market price calculation for bond:  Market price calculation for bond Slide20:  Treasury bonds are quoted in dollars and thirty-seconds of a dollar. The quoted price is for a bond with a face value of $100. Thus a quote of 90-05 means that the indicated price for a bond with a face value of $100,000 is $90,156.25. Similarly, a quote of 99-30 with a face value of $100,000 is _________. Slide21:  The quoted price is not the same as the cash price that is paid by the purchaser. Cash price = quoted price + Accrued interest since the last coupon date. To illustrate the formula: Suppose that it is March 5, 2001 and the bond under consideration is an 11 percent coupon bond maturing on July `0, 2005 with a quoted price of $95-16. For government bonds, coupons are paid semiannually. The most recent coupon date is January 10, 2001 and the next date is July 10, 2001. Slide22:  The number days between Jan. 10 and March 5 is 54, whereas the number of days between Jan.10 and July 10 is 181. On a bond with a face value of $100, the coupon payment is $5.5 on Jan.10 and July 10. The accrued interest on March 5 =$5.5*54/181= $1.64 The cash price per $100 face value for the July 10, 2005 bond is therefore: $95.5+$1.64=$97.14 Thus the cash price of $100,000 bond is $97, 140. Currency hedging:  Currency hedging Short vs long currency hedging Short hedge: dollar appreciation Long hedge: Dollar depreciation Short Hedging:  Short Hedging A U.S. firm that has an export sale to U.K. with payment to be made in British pounds faces the risk that pound, relative to dollar, will depreciate. Example: At the current rate of $1.4 per pound, U.S. exporter has agreed to receive 100,000 pounds ($140,000) for the merchandise. If the exchange rate changes to $1.35, the exporter still receive 100,000 pounds. But exchange rate fluctuations has reduced his profit by $5,000. Currency Hedging:  Currency Hedging Similarly, if you are foreign investor, then you are faced with the risk of dollar appreciation. Example: An investor is planning to invest 100,000 U.S. dollars in Canada at the current exchange rate of 0.9 U.S. $ per Canadian dollar. Investor is expected to earn 3,000 C$ in three months. If the exchange rate remains at the current rate, he will earn: (111,111+3,000) Canadian dollars or 102,700 U.S. dollar If the exchange rate appreciates to 0.85, then he will earn: 114,111C$ or 96, 995 U.S. $. Long Hedging:  Long Hedging Long Hedging protects against dollar depreciating relative to other currencies. This typically involves selling a foreign currency and buying dollars and then later selling the dollars and buying foreign currency. Delta:  Delta The relationship between the change in the option premium and the price of the underlying futures is called delta (Δ). Delta=Change in the option premium/ Change in the price of the futures Delta normally ranges between zero and one. A delta of 0.9 means that when the underlying futures price changes by $1.00, the option premium changes by only $0.90. Deltas of 1 means perfect correlation between changes of the futures price and the option premium and deltas of 0 means that the option premium did not change when the futures price changes. Delta:  Delta Delta (D) is the rate of change of the option price with respect to the underlying Slide33:  As a general rule, delta value increases as the option gets deeper in-the-money and becomes the value of one. As the option goes deeper out of the money the delta value becomes close to zero. Delta takes on the values of zero or one as the option approaches maturity when the time value is eroded away and the probability of a significant price moves is effectively zero. Hedging Strategies: Livestock and Meat Complex:  Hedging Strategies: Livestock and Meat Complex Cattle Futures contracts:  Cattle Futures contracts Two futures contracts can be used for hedging: the feeder cattle contract (700-849 pounds animal) and the live (fed) cattle contract (1,100-1300 pounds animal) Each of the livestock contracts call for a semi truckload unit: Feeder cattle: 50,000 pounds Live cattle: 40,000 pounds In addition, CME has also listed some products such as boneless beef and ground beef. Hog Contracts:  Hog Contracts Hog contracts allow both barrow (castrated male) and gilts (nonpregnant female) that averages 220 pounds. Since there is no feeder pig contract, only the live market hog contract can be hedged. Live Cattle Hedge:  Live Cattle Hedge Either anticipatory or purchased hedges. An anticipatory hedge is one that is placed by someone that has the cattle in a growing program and anticipate that they will put them in a finishing operation. A purchased hedge is placed by someone who buys cattle they are ready to be put into a finishing program. Live Cattle Hedge:  Live Cattle Hedge The risk is that while the cattle are growing and being finished in the feed yard, the price of live cattle will decrease, sometimes far enough to eliminate all profit margins. Hog Hedge:  Hog Hedge Either anticipatory or purchased hedges. An anticipatory hedge is placed by someone that has the hogs in a growing program and who plans to move them into a finishing program. A purchased hedge is placed by someone who buys hogs they are ready to be put into a finishing program. Investing as a speculator:  Investing as a speculator Speculators in futures markets do not own or control the underlying commodity. They invest in futures markets to try and capture profits from price movements/price forecasting. The major attraction of speculative investors to the futures market is the leverage made possible by the margin system. Investing as a speculator:  Investing as a speculator There are three major ways in which to invest as a speculator in the futures markets Short term Long term Spreading Short term: Investors who trade on a daily or within-the-daily basis to profit from the price fluctuations Short term speculators:  Short term speculators The most celebrated of all day traders are the scalpers (also known as locals) Mostly exchange members Trade on very small price movements and concentrate on a large volume of trade to generate income Locals usually end the day without holding any open position, i.e., they offset all the trade by the end of the day. Spreaders:  Spreaders Spreading involves price relationships in two or more markets. Spreaders try to estimate price relationships between or among close related markets and try to take advantage of any abnormality. Example: Consider corn futures prices for March and May contracts. Price difference between these two contracts should be carrying charge. If the average carrying charge is 3 cents per month, then the normal relationship between March and May futures should be 6 cents. If the difference is 8 cents then you would put a spread by buying March contract and selling May contract. Spreaders:  Spreaders A similar situation exists when the spread is narrower than normal. Reverse spreading relationship on corn futures Feb 1: March corn is trading at $2.1 and May corn is trading at $2.14 Sell March corn and buy May corn When the spread relationship has gone back to normal, lift the reverse spread Spreaders:  Spreaders Spread investing is relatively less risky because gains made on either the buy or sell side are usually offset by losses on other side. The margin requirement for spread is much less than for short or long-term speculator Spreader will spread temporal, spatial, form and substitutional relationships. Types of spread:  Types of spread Temporal relationships involve carrying charges such as storable commodities such as corn, wheat and soybean Spatial spread: The price relationship between gold trading in New York Futures gold and Chicago Futures gold Form Spread: The soybean complex offer form spread because both soybean and products have futures contract Substitutional spread:

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