Question

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

b.   What are advantages of futures options over spot options?

c.   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 your answer.

(3+3+4 = 10 marks)

Answer 1

A. There are different ways a company can hedge its foreign currency receivables or payables, some of those methods are provided below:

1. Forward Contracts - This is an over the counter agreement between tho parties to exchange foreign exchange at predetermined rate on predetermined date.

2. Futures Contracts - These contracts are traded on exchange to trade currency at future date at fixed rate.

B. Advantages of futures options over spot options.

In Futures options the underlying is " the futures price" on the other hand in spot options the underlying is "spot price in future". Therefore futures options can be used as effective hedge against a portfolio of futures position however spot options will not be a proper hedge against the portfolio of futures positions.

C. Vega measures an options' price value change with respect to change in volatility of underlying. One can assess that how much effect change in volatility will have on the price of option. By this way one can assess the sensitivity of portfolio to volatility in underlying.

As vega is dependent on the volatility of underlying hence if taking position will have effect on the volatility of underlying then it will impact vega too.

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