Bear Put Spread - Currency Management

CFA Level III Fixed Income
#1

Hi everyone,

I have a question regarding the Bear put spread currency hedging strategy.

Assume we want to hedge long exposure to CHF.

In the SchweserNotes (Book 4, Study Session 10, Reading #21, page 194) it is said that with this strategy: “There is downside protection, which begins at the strike price of the purchased puts, but if the CHF falls below the lower strike price of the put sold, that downside protection is lost.”

But looking at the diagram of a bear put strategy as well as the payoff (=max(0,XH-ST)-max(0,XL-ST)-PH+PL) function I just can’t figure out when the price of the underlying is decreasing why the downside protection is lost? With prices lower than XL I always obtain a positive result.

Thanks a lot

#2

The diagram is strictly options… it does not assume you have an underlying. Since you do have an underlying (because you’re using it as a hedge), no more profits are being made from the bear spread after the lower strike, and your underlying is LOSING mula money at that point.

#3

Ok got it.

So I suppose I would need to add (St-S0) to get the correct payoff.

#4

Ok got it.

So I suppose I would need to add (St-S0) to get the correct payoff.

#5

I don’t. The bear put spread gains when the underlying price falls below the lower strike.

Both options are called you gain XH - XL - net option cost.

Is this sth I totally screwed up???

#6

Maybe the book was trying to explain that if you had bought only the long put, your protection would be better because the payoff would be XH - St instead of XH - XL. On a bear put spread you cannot earn more than the difference btw. the two strike prices minus the option cost, while a sole long put would give you better outcome if the underlying is losing.

I don’t have Schweser.

#7

Well I believe we must consider the fact that we are using the Put Bear Spread under different circumstances when we implement it for a currency hedge.

Previously I was referring to a situation when we have a long position in an asset (in this case the underlying is a currency) and we need to find a hedge for it. So one of the possibilities is to create a put bear spread (PH-PL).

However, we need to consider the underlying we already posses and whose value at expiration is equal to ST and was purchased at S0. So we would need to add (ST -S0) to the option strategy payoff function. Indeed, this circumstances make the hedge strategy valuable only if the price of the underlying ST stays between XH and XL (which we are betting on when we create the hedge). In this case, the downside potential is reduced.

That is why I was referring to a currency HEDGE and not a pure option strategy of a Bear Put Spread as the circumstances under which we use this combination are different.

#8

I found an example by Nicolas.joun from last year: https://www.analystforum.com/forums/cfa-forums/cfa-level-iii-forum/91362622

He states following:

Let’s make few assumptions:

S0 = the price you originally bought your stock at, say at $45

ST =is the current market price of the underlying

P1 = is the premium received (normally lower), let’s assume it’s 1$

P2 = is the premium paid and let’s assume it’s 2$

Now let’s draw the profit/loss diagram:

Strategy = Stock position + Bear Put strategy = Short put (X1 = $40) + Long Put (X2 = $50)

= ST – S0 + -(X – ST) + (X – ST) - (P1 – P2)

At ST= 41 = 41 – 45 + Won’t exercise + (50 – 41) - (2 – 1) = $4

At ST= 45 = 45 - 45 + Won’t exercise + (50 – 45) - (2 - 1) = $4

At ST = 48 = 48 – 45 + Won’t exercise + (50 – 48) - (2 – 1) = $4

Notice above, when the underlying ST is anywhere between X1 & X2 you’re protected

Now let’s turn to scenarios beyond X1 & X2 :

At ST = 52 = 52 - 45 Won’t exercise + Won’t exercise - (2 - 1) = $6

At ST = 38 = 38 - 45 -(40 – 38) + (50 – 38) - (2 – 1) = $2

At ST = 35 = 35 – 45 -(40 – 35) + (50 – 35) - (2 – 1) = -$1

Notice how you started losing the protection when the underlying is below X1