Lets take the example in the CFA book REading 46 Insuring with options Page 173 Trying to hedge 1Mn Euro assets. Spot 1$ = 1Euro 3 month forward exchange rate $0.996 = 1 euro Put Euro option premium : 3 cents for strike price of $1 per euro if we need to hedge the portfolio, then we need to buy a million option costing 30K. let us assume delta = 0.5, this means that if I go for delta hedging, I need to buy double the amount of option paying 60K and then rebalancing continuously to adjust for change in delta. Why would someone do that? what is a good scenario to do dynamic hedging comapred to just buy the option and leave it at that.
b/c they want to hedge the value without the downside risk associated with futures/forwards I guess.
You buy insurance (option) for a certain amount. Because exchange rates (int rates, prices) change with time, that amount changes as well. If the amount goes up, your insurance (option) coverage will not be enough to cover the new amount, hence the need to do rebalancing (dynamic hedging).
am not askign about forward/future vs dynamic hedging. In the above example, I can buy mn put option and then forget it till I happen to excercise it or forego the premium if I am gaining in the currency. Dynamic option calls for a different strategy where you continuously buy/sell addtional puts depending on option delta. why would you do that if you could set it and leave…
b/c the Delta isnt 1 that means you will end up over or under hedging your position if you dont adjust.
shark 777 explain it bit further applying your theory to the above example I have quoted. thanks
Krishna when you are uncertain of which direction the currency is going to move you should use options because it will minimize your losses while retaining your currency gain potential. If you use Futures/Forwards you will also minimize losses BUT you giveup any currency gains.
I understand that. My question is specific to do with insuring with options compared to dynamic hedging.
I don’t have the CFAI books with me and I am not good at solving these. I just know the theory behind it.
bigwilly Wrote: ------------------------------------------------------- > Krishna when you are uncertain of which direction > the currency is going to move you should use > options because it will minimize your losses while > retaining your currency gain potential. If you > use Futures/Forwards you will also minimize losses > BUT you giveup any currency gain
Ha sorry, First time using the computer