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Hedging foreign exchange risk

7.5 Traded options hedging calculations

1 Now – set up the hedge

– Call or put options? Look at the currency of the contract (“CC”)

– Which expiry date? First contract to expire after transaction date

– How many contracts? Look at contract size. May need to round.
May need to convert currencies to match transaction

– Which strike price? Choose the most beneficial

2 Contact the exchange and pay the premium.

3 Future transaction date – compare the option price with the prevailing
spot rate and make decision – to exercise or allow to lapse?

4 Calculate net cash flows. The options may not match exactly with the
future transaction so extra exchanges may be necessary to address

any over- or under- hedge.

Illustrations and further practice

Now try TYU 4 and TYU 5 in Chapter 10

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