Derivatives seagull structure- not understanding

CFA Level III Derivatives
#1

Exhibit 3

Spot and Forward Rates for AUD and CHF

Currency Pair Current Spot Rate Six-Month Forward Rate Six-Month Forecast Spot Rate
BRL/AUD 2.1046 2.1523 2.0355
BRL/CHF 2.5309 2.4641 2.5642

Traldi suggests that the use of put options might be a better way to hedge currency exposure. Campos responds that there are better options-based strategies that can exploit market views and reduce hedging costs. She suggests the following strategies:

  • Strategy 1: For AUD exposure, the appropriate strategy is to be long put options at a strike price of 2.1046, short put options with a strike price 2.1006, and short call options with a strike price of 2.1456.
  • Strategy 2: For CHF exposure, the appropriate strategy is to be long put options at a strike price of 2.5309, short put options with a strike price 2.5049, and short call options with a strike price of 2.5669.

Question

Is Campos most likely correct that Strategy 1 and Strategy 2 will accomplish the goals of exploiting market views and reducing hedging costs?

  1. No, she is incorrect about reducing hedging costs.
  2. No, she is incorrect about exploiting market views.
  3. Yes.

Solution

Solution

B is correct. Campos suggests that both strategies help reduce hedging costs and allow the manager to exploit a market view. While it is true that both strategies help reduce hedging costs through premiums collected on short calls and puts, they both do not exploit the market view on the currencies, specifically, Strategy 1 does not. Exhibit 3 indicates that the expectation is for the AUD to depreciate to BRL/AUD 2.0355 and for the CHF to appreciate to BRL/CHF 2.5642. Strategy 1, the short seagull on the AUD, only provides downside protection to BRL/AUD 2.1006 (when the short put kicks in and neutralizes the hedge), not BRL/AUD 2.0355. Under Strategy 2, the expectation is for an appreciation to BRL/CHF 2.5642; here the option premium is pocketed and because the option is written with a strike of BRL/CHF 2.5669, it will expire worthless if the rate never gets to BRL/CHF 2.5669

My confusion: There is a short call of 2.1456 in strategy 1 that would help with the forecast rate right? How come we only use the short call in strategy 2 and not 1?

#2

Because AUD is depreciating i.e. BRL is appreciating. If BRL was depreciating, the short call would have been considered

#3

Hi

What I don’t understand is why strategy 2 is not good. He wants to pocket the premium by being short the call whose strike is higher than the projected spot rate so it won’t be exercised and he will get the premium with the downside protection (long ATM put) financed with OTM short put.

Thanks if someone can explain.

#4

Maybe cuz market views are conflicting. Fwd rate is predicting an appreciation for BRL/CHF while forecast is predicting a depreciation

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#5

The first question to ask is why the spot rates are so stupid.

BRL/AUD is 3.4169 today, and BRL/CHF is 5.0118.

Seriously, if you’re going to write such a question, can’t you do even the barest minimum of research first?

#6

Strategy 2 - CHF does not need hedging based on projected spot (market views) - hence limited exploration of market views

The spot as is appreciating giving forward bias; hedging is only costing and making the position worse given market views

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#7

Hedging cost has been net off so that is okay

however, can u say for certain that u trust your forecast when the fwd market is showing that it might depreciate. Can anyone be really that confident