This question is making me have a headache (literally), please help me understand
Jasmine Khan, one of the analysts at Brixworth & St. Ives, proposes an option-based hedge structure for the long-ZAR exposure that would replace the hedge based on the ATM call option with either long or short positions in the following three options on ZAR/GBP:
a ATM put option b 25-delta put option c 25-delta call option
Khan argues that these three options can be combined into a hedge structure that will have some limited downside risk, but provide complete hedge protection starting at the relevant 25-delta strike level. The structure will also have unlimited upside potential, although this will not start until the ZAR/GBP exchange rate moves to the relevant 25-delta strike level. Finally, this structure can be created at a relatively low cost because it involves option writing.
Question. Setting up Khan’s proposed hedge structure would most likely involve being: A long the 25-delta options and short the ATM option. B long the 25-delta call, and short both the ATM and 25-delta put options. C short the 25-delta call, and long both the ATM and 25-delta put options.
Answer A This means the hedge needs to protect against an appreciation of the GBP (an appreciation of the ZAR/GBP rate). Based on Khan’s description, the hedge provides protection after a certain loss point, which would be a long 25-delta call. Unlimited upside potential after favorable (i.e., down) moves in the ZAR/GBP past a certain level means a long 25-delta put. Getting the low net cost that Khan refers to means that the cost of these two long positions is financed by selling the ATM option.
What I don’t understand is why do we need to long the 25 delta put option, and at what point are we going to exercise such an option? Our risk is that GBP may appreciate, which require a call option to hedge, we can reduce the cost of the initial long call by either writing a deeper out of the money call and/or an out of the money put. Short put will limit upside potential and short deeper out of the money call will limit downside protection. Where does long put come into play here?
I suspect that the reason that this isn’t immediately clear to you is that they (deviously) decided to quote ZAR/GBP options, instead of GBP/ZAR options.
If they’d said that B&SI were concerned about a decrease in GBP/ZAR (they don’t want to get fewer GBP for each ZER they’ll have to sell) and wanted to buy put options on that rate, you’d probably say, “Of course! That makes sense.”
Well, a call option on ZAR/GBP is the same as a put option on GBP/ZAR.
I presume that this should read “long 25-delta call options . . . .” Yes?
It says long 25-delta options since they are 25-delta call option and 25-delta put option, so long both.
Your explanation does make completely sense because that would mean long put to hedge the selling price of ZAR. The problem is that in the reading they specifically said in order to avoid confusion we must always work on either selling or buying the base, therefore we must hedge either the selling or buying price of the base. So coming back to the question, the GBP is the base and in this case we are buying the base which means we must hedge the buying price of the GBP. For that reason I don’t understand why buying a put will hedge the buying price of GBP.
My apologies: I didn’t read the vignette carefully. I missed the unlimited upside requirement.
Answer A, when combined with the existing currency position, results in a seagull spread. Technically, it’s a long bearish seagull spread.
Think of it this way: Khan has a long position in ZAR, which is equivalent to a short position in GBP (this is the key bit of understanding that makes the rest of this clear); she will have to sell ZAR in the future and buy GBP. Therefore, she’s worried that the price of GBP will increase, but she’ll be happy if the price decreases. When you hold a short position, one way to protect against a price increase is a (short) collar: buy an OTM (i.e., high strike) call and finance it by selling a put with a lower strike. Here, Khan can do that by buying a 25-delta call and selling an ATM put. She’s protected the downside in case of a price increase, but she has no upside. Because she wants upside, she adds another option: she buys a 25-delta put. If the price of GBP falls below the strike on that put, she starts to profit.
I can’t draw the full payoff on the seagull, but I can get close. The payoff on the (short) collar looks like this: ¯\_. For the seagull, on the left end of that payoff, add another leg that goes up to the left.
Thanks a lot! This makes it clear now, I will just paraphrase to show my understanding: The purpose of the long 25-delta put is not for protection, rather it’s there to profit should GBP price decreases way down pass the 25-delta put. Should GBP decrease, the ATM put we short will be exercised by counter- party, they will buy GBP from us which means we will receive ZAR. But if the price of GBP continue decreasing passing our long 25-delta put we can then exercise our put and buy back the GBP (Selling the ZAR) at lower price, thereby realizing a profit. When the price of GBP is between the strikes of the short ATM put and long 25-delta put, we don’t profit.
Hi, I understand why option A is the correct answer, but I don’t see how the net position turns into a long bearish seagull spread. Doesn’t it also contradict the fact that we need an unlimited upside potential? A long bearish seagull spread implies unlimited downside risk, and limited upside potential no?
A short bearish seagull has limited upside and unlimited downside. It’s essentially a bear spread plus a short call with a strike higher than the higher strike on the bear spread.