What’s the rationale of chosing mid-market price for the Spot Leg in the matched hedge; while using bid-side price in the unmatched hedge?
Is there a logical reason? I hope it’s not one of those: a farmer buys a sea-side mansion at sub prime; MBS; MBS ratings; trading MBS; Insuring MBS; CDO Trading; huge undistributed profits; huge distributed bonuses for the huge undistributed profits; … confused? good, we have your money and doing “stuff” with it. It’s technical.
In the matched swap, it’s easier to roll forward the contract as it’s the same amount. So they use mid spot.
In the unmatched swap (presumably higher amount to hedge), it’s more risk for the dealer or perhaps more cost for the delaer to get the extra amount for the participant. So, they will provide the offer side (not bid if you are buying the base currency).
I’ve seen examples where the unmatched difference is less than 3%. Why affect the 97% just to incorporate the 3%? I’ll just remember it as is for the exam.
Though it provides good argument for hedge fund managers to charge more.
I remember we need to weigh average it, i.e. matched amount using mid-price and the additional part using bid-side.
What confused me about this is that the dealer quoted the bid side when the hedger was both selling the base forward and buying the base spot (in a mis-matched hedge).
Can anyone explain this?
P.S - In the example, the hedger is increasing the size of the short Euro forward position (EUR base). Hence it makes sense for the dealer to use the bid not the offer. What confuses me is why the dealer wouldn’t use the bid price when the hedger shorts the forward and the offer price when he/she buys the spot.
I’m totally lost in this BB. It doesn’ make any sense from what we’ve learned with FX.
Because the EUR is the base currency in the HKD/EUR quote, this means using the bid side for both the spot rate and the forward points when calculating the all-in forward rate.
Why?? When buying the curency we don’t use Offer? Why has it to do with base currency?
which BB are you talking about?
3 steps in determining your forward rate
Obviously, if the base currency is switched to HKD (meaning if the exchange rate is given to you as EUR/HKD), since you are selling EUR & buying the base, HKD , the ask rate needs to be used.
in a matched swap (same principal), you use the mid rate as your spot +/- forward premium/discount (in terms of base)
in a unmatched swap (over/underhedging), use the bid or ask rate as spot +/- forward premium/discount (in terms of base)
Matched:
You’re buying back one currency and selling the other, ends up being an average of the bid/ask since your transaction is in both
That buying base= ask rate, selling base = bid rate doesn’t seem to apply in this BB. That’s why I’m confused.
Below is from the CFAI material:
The following spot exchange rates and three-month forward points are in effect when Yang transacts the FX swaps necessary to roll the hedges forward:
Spot Rate** Three-Month Forward Points** JPY/HKD 10.80/10.82 –20/–14 HKD/EUR 10.0200/10.0210 125/135
For Hedge #2 , the foreign-currency value of the underlying assets has increased; Yang recognizes that this implies that she should increase the size of the hedge greater than EUR8,000,000. She also believes that theHKD/EUR spot rate will depreciate, and recognizes that this implies a hedge ratio of more than 100% (Kwun Tong Advisors has given her discretion to over- or under-hedge based on her market views). This too means that the size of the hedge should be increased more than EUR8,000,000, because Yang will want a larger short position in the EUR to take advantage of its expected depreciation. Hence, Yang uses a mismatched swap,buying EUR8,000,000 at spot rate against the HKD, to settle the maturing forward contract and then selling an amount more than EUR8,000,000 forward to increase the hedge size. Because the EUR is the base currency in the HKD/EUR quote, this means using the bid side for both the spot rate and the forward points when calculating the all-in forward rate:
10.0200+12510,000=10.0325
10.02 + 125/10000 = 10.0325
The spot leg of the swap—buying back EUR8,000,000 to settle the outstanding forward transaction—is also based on the bid rate of 10.0200. This is because Yang is selling an amount larger than EUR8,000,000 forward,and the all-in forward rate of the swap is already using the bid side of the market (as it would for a matched swap). Hence, to pick up the net increase in forward EUR sales, the dealer Yang is transacting with would price the swap so that Yang also has to use bid side of the spot quote for the spot transaction used to settle the maturing forward contract.
They are buying EUR at spot leg, why are they using bid? Is it because they are using bid for all-in-forward?
I wrote the original post in a dark long night (earth was rotating slower than usual). I’ve got the rational by now. They opted for a simple mathematical equation that self correct for weights of original vs additional hedged amounts. From my perspective this should had been done in one equation that incorporate weight (weighted midprice origional + weighted bid/ask increase/decrease). But their way works just fine.
I don’t understand this part too.
>> The spot leg of the swap—buying back EUR8,000,000 to settle the outstanding forward transaction—is also based on the bid rate of 10.0200. This is because Yang is selling an amount larger than EUR8,000,000 forward,and the all-in forward rate of the swap is already using the bid side of the market (as it would for a matched swap). Hence, to pick up the net increase in forward EUR sales, the dealer Yang is transacting with would price the swap so that Yang also has to use bid side of the spot quote for the spot transaction used to settle the maturing forward contract.
Why are they using bid side of the quote for spot leg of the swap?