Question

Question 6

i) What does vega measure? What can you tell from vega value? Can the vega of a derivatives portfolio be changed by taking a position in the underlying asset? Explain.

ii) What are advantages of futures options over spot options?

iii) What a company should do to hedge foreign currency that will be received or paid? Explain.

If possible, please provide a detailed explanation as I understand the gist of it but would like a full understanding and not just copy answers. Thank you :)

Answer 1

Vega is the calculation of an option's (Put or call option) price sensitivity to changes in the volatility of the underlying asset (For eg share, etc)

Vega represents the amount that an option contract's price changes in reaction to a 1% change in the implied volatility of the underlying asset. for eg if share price changes by 1%, and call / put option price changes by 0.5%, Vega of call / put option is 0.5.

Vega is large for options that have more time left for expiry and is lower for options which are about to expire.

The vega of a derivatives portfolio cannot be changed by taking a position in the underlying asset because a long or short position in underlying asset has zero vega. This is because its value does not change when volatility changes.

ii) Advantages of futures options over spot options are

1. Futures are best for buying / selling index, currency, commodity - Standardized features and very high levels of leverage are key advantages for the risk-tolerant retail investor. The high leverage helps investors to participate in markets to which they might not have had access otherwise.

2. Transaction costs are fixed and known -  A trader knows in advance how much has to be put up as initial margin. On the other hand, the option premium paid by an option buyer can vary significantly, depending on the volatility of the underlying asset and broad market.

3. Zero time decay - Options are wasting assets, which means their value declines over time while futures, on the other hand, do not have time decay.

4. Liquidity - Futures market is very deep and liquid .i.e. it has narrow bid ask spread and investor can take reverse position and leave the transaction after booking his profit or loss. Options maeket is not liquid

5. Easy to understand Futures Pricing - The futures price should be the same as

the current spot price + the cost of carrying (or storing) the underlying asset until the maturity of the futures contract. If the spot and futures prices are out of alignment, arbitrage activity would occur and rectify the imbalance.

Option pricing is based on the Black-Scholes Model, which uses a number of inputs and is complex for the investor to understand.

iii) What a company should do to hedge foreign currency that will be received or paid

Multinational Firms that trade across countries have foreign currency inflow and outflow. In order to protect itself for Foreign exchange loss, MNC's undertake Currency swap. Suppose, Microsoft needs to pay 100 Mn American Dollars in 3 months time, it may protect itself by purchasing a forward contract in which it sells USD and buys AUD at a price predetermined now. Thus, its exposure is fixed in terms of USD and AUD.