Seminar Six

Managing in Financial Markets Using Force Derivatives for Hedging You are the manager of a stock portfolio for a financial institution, and about 20 percent of the stock portfolio that you manage is in British stocks.

You expect the British stock market to perform well over the next year, and you plan to sell the stocks one year from now (and will convert the British pounds received to dollars at teatime). However, you are concerned that the British pound may depreciate against the dollar over the next year. . Explain how you could use a forward contract to hedge the exchange rate risk associated with your position in British stocks. You could use a forward contract to hedge the exchange rate risk by setting how much money/ pounds you want in one year. You would do this to lower risk, since you’re concerned that the British pound may depreciate against the dollar over the next year.

B. If interest rate parity holds, does this limit the effectiveness of a forward contract as a hedge?

If there is an interest rate parity hold, I don’t think it would limit the effectiveness of a forward contract since it would already be reflected in the premium. C. Explain how you could use an options contract to hedge the exchange rate risk associated with your position in stocks. You could hedge the exchange rate risk by using put options, which would specify the lowest exchange rate that the pounds can be sold. D.

Assume that, although you are concerned about the potential decline in the pound ‘s value, you also believe that the pound could appreciate against the dollar over the next year.

You would like to benefit from the potential appreciation but also wish to hedge against the possible depreciation. Should you use a forward contract or options contracts to hedge your position? Explain. I think It would be best to use a put options contract to hedge your position. By doing so you lock in lowest exchange rate that It can be sold, which protects you If the pound depreciates against the dollar. In addition, If the pound appreciates, you would have the benefit to let the contract expire at year end and sell at a better price.