Seagull Strategies

CFAI online practice - Sabanai Investimentos Case Scenario

Exhibit 3

Spot and Forward Rates for AUD and CHF

Currency Pair** Current Spot Rate Six-Month Forward Rate Six-Month Forecast Spot Rate** BRL/AUD 2.1046 2.1523 2.0355 BRL/CHF 2.5309 2.4641 2.5642

Traldi suggests that the use of put options might be a better way to hedge currency exposure. Campos responds that there are better options-based strategies that can exploit market views and reduce hedging costs. She suggests the following strategies:

  • Strategy 1: For AUD exposure, the appropriate strategy is to be long put options at a strike price of 2.1046, short put options with a strike price 2.1006, and short call options with a strike price of 2.1456.
  • Strategy 2: For CHF exposure, the appropriate strategy is to be long put options at a strike price of 2.5309, short put options with a strike price 2.5049, and short call options with a strike price of 2.5669.

Q. Is Campos most likely correct that Strategy 1 and Strategy 2 will accomplish the goals of exploiting market views and reducing hedging costs?

  1. No, she is incorrect about reducing hedging costs.
  2. No, she is incorrect about exploiting market views.
  3. Yes.
    Solution

B is correct. Campos suggests that both strategies help reduce hedging costs and allow the manager to exploit a market view. While it is true that both strategies help reduce hedging costs through premiums collected on short calls and puts, they both do not exploit the market view on the currencies, specifically, Strategy 1 does not. Exhibit 3 indicates that the expectation is for the AUD to depreciate to BRL/AUD 2.0355 and for the CHF to appreciate to BRL/CHF 2.5642. Strategy 1, the short seagull on the AUD, only provides downside protection to BRL/AUD 2.1006 (when the short put kicks in and neutralizes the hedge), not BRL/AUD 2.0355. Under Strategy 2, the expectation is for an appreciation to BRL/CHF 2.5642; here the option premium is pocketed and because the option is written with a strike of BRL/CHF 2.5669, it will expire worthless if the rate never gets to BRL/CHF 2.5669.

.

My question: are both strategies incorrect or just strategy 2 incorrect, the solution confuses me “they _ both do not _ exploit the market view on the currencies, _ specifically, Strategy 1 does not _”

Both strategies are incorrect regarding exploiting market views.

Strategy 1 is especially bad at it as the rate is expected to drop to 2.0355 but he shorts the put at 2.1006, which limits the upside. Should have not short the put if he wanted to exploit the market view (if the exchange rate in 6 months is equal to the forecasted FX rate).

For Strategy 2, should have long call at 2.5309 since rates expected to increase. The short call should be at 2.56642 to get higher premium.