Derivatives in Hedging or Speculation

Show how transactions in derivative instruments can be used to either hedge risks or to open speculative positions

1. Contents

I.        Introduction        2

II.        FX Derivatives        2

i.        FX Forward        2

ii.        FX Options        3

iii.        Combination of Options        5

III.        Interest Rates Derivatives        5

i.        Interest rate swap        5

ii.        Combining swaps        6

iii.        Combining FX and interest rate components: Cross-currency swaps        7

IV.        Equities and Commodities Derivatives        8

i.        Contracts for difference        8

ii.        Index Return Swaps        8

V.        Other Derivatives        9

VI.        Conclusion        9

VII.        Bibliography        10

1. Introduction

Derivatives are, as the name implies, instruments whose value and payoff derive from the value of its underlying asset(s). Common underlying instruments include bonds, currencies, interest rates and equities. Throughout the history of finance, derivatives have been used for a variety of purposes, such as hedging against price movements, create access to illiquid products or increase exposure to earlier said price movements. Depending on the extensiveness of each instrument’s use, these derivatives may or may not be traded centrally through an exchange. More commonly than not, they are traded over-the-counter, with customized contracts between each counterparty. The size of the derivatives market alone warrants this instrument a detailed discussion – in 2010, the value of OTC derivatives exceeded $600 trillion whilst the underlying market was only $21 trillion (Liu & Lejot, 2013). I will therefore explore this topic methodically through every major underlying asset class, provide examples of how hypothetical MNC corporates or investor can use derivatives to fulfill his hedging needs and how the exact same instrument can be used by a hypothetical hedge fund to speculate.

1. FX Derivatives

1. FX Forward

FX forward is a type of instruments where the counterparty A enters into an agreement with a counterparty B to exchange Currency 1 for Currency 2 for a fixed notional on a certain stipulated date in the future at an agreed exchange rate.

Given an Airline Co listed on London Stock Exchange with majority of its cashflows in GBP but large exposure to USD due to dollar-denominated oil contracts, its fuel expense and therefore its EBIDTA can be sensitive to exchange rate movements. Assuming Airline Co needs to pay 1 million in USD every quarter, the firm can enter into sell GBP buy USD forwards every quarter for the next year. This helps to hedge against FX rate movements as the rates are locked in. A 3-month Forward for Airline Co will be transacted at 1.39753 (spot) + 58.73/10000 = 1.4034.

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Figure 1 GBP/USD forwards (Barchart, 2018)

Forward rates are very transparent as they are built interest-rate parity. For the corporate, its payoff will be the following, where K is the forward rate.

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Figure 2 FX forward payoff diagram

If in 3 months’ time, GBP depreciates against USD to reach 1.39 due to lack of progress and further hurdles on Brexit, then Airline Co has benefitted as it is able to buy USD 1 million with GBP 712,555 rather than the GBP 719,424 needed on the market then, giving a gain of GBP 6,869. Airline Co is able to hedge 100% of its USD exposure as long as it buys forwards on 100% of its notional exposure.

This instrument is used primarily for hedging and less for speculation as it is an obligation derivative (Berkman & Bradbury, 1996).

1. FX Options

Whilst the forward represents an obligation to exchange at a future date, FX Options give the right but not the obligation to exchange (Kolb, 2010). Options can be calls or puts, which means to right to buy or right to sell. The same Airline Co can hedge its currency exposure by purchasing a GBP put USD call at an in-the-money strike 1.41 in 3 months’ time for the price of 1.32% (Figure 2). This means that Airline Co has the right to sell GBPUSD at 1.41, or in other words it can definitely purchase $1 million with GBP 709,220. However, the cost of the option is rather expensive at 1.32% ⬄ GBP 9,362. Therefore, in 3 months’ time, GBP has to depreciate to 1.39163 in order for this option to breakeven as per the payoff in Figure 4. The downside of choosing to hedge with such a put is that Airline Co will not be able to participate in any upside of GBP appreciation. If GBP appreciates to be greater than 1.41 in 3 months’ time, the option expires worthless / out-of-money and loses the money it paid for the option. One way to reduce the cost of such FX options is to purchase out-of-money options.

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Figure 3 GBPUSD Option prices (Investing.com, 2018)

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Figure 4 Payoff diagram for buying a FX put

On the other hand, a hedge fund can use FX options to speculate on the prices of many currencies. Whilst corporates view options as a cheaper alternative to hedge, hedge funds find it useful to create large amounts of leverage. The same 1.41 strike 3-month put allows GBP 2 million capital to successfully create exposure on GBP 152 million of underlying FX forwards.

In addition, the transactability of FX options can be used to speculate on not only the underlying asset but also the derivatives itself. For example, when news influencing GBP are going to be released, this can affect the volatility of the GBP currency trading pairs. If a hedge funds speculates contrary to market belief that May and the UK government will not be able to negotiate a successful Brexit outcome, leading to rising volatility in GBP forex exchange pairs, it should purchase GBP/XXX options now. As FX options’ price rise with volatility, the hedge fund can re-sell these options back to the market when volatility actually increases to profit off the value increase of the options.