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.
Q. Is Campos most likely correct that Strategy 1 and Strategy 2 will accomplish the goals of exploiting market views and reducing hedging costs?
No, she is incorrect about reducing hedging costs.
No, she is incorrect about exploiting market views.
Yes.
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 question: are both strategies incorrect or just strategy 2 incorrect, the solution confuses me “they _ both do not _ exploit the market view on the currencies, _ specifically, Strategy 1 does not _”
Both strategies are incorrect regarding exploiting market views.
Strategy 1 is especially bad at it as the rate is expected to drop to 2.0355 but he shorts the put at 2.1006, which limits the upside. Should have not short the put if he wanted to exploit the market view (if the exchange rate in 6 months is equal to the forecasted FX rate).
For Strategy 2, should have long call at 2.5309 since rates expected to increase. The short call should be at 2.56642 to get higher premium.
You can think of a seagull spread as either a bear spread or else a bull spread along with an extra call or put option. The seagull spreads the curriculum discusses are bullish:
Their long seagull (properly a long bullish seagull) is equivalent to a bull spread plus a long call whose strike is above the higher strike in the bull spread
Their short seagull (properly a short bullish seagull) is equivalent to a bull spread plus a short put whose strike is below the lower strike in the bull spread
There are apparently two common ways to choose the strikes for a seagull spread:
Choose the strikes on the bull spread as you normally would: one below the spot and one above the spot
For a long seagull, choose the strikes on the bull spread so that the higher strike is equal (or as close as you can get) to the spot price
For a short seagull, choose the strikes on the bull spread so that the lower strike is equal (or as close as you can get) to the spot price
Note that for the last two, that puts the middle strike on the seagull at (or as close as possible to) the spot price.
I had the same issue with the problem and I don’t understand what we are doing by setting up a seagull and don’t even understand how to set it up. THe book is awful in the explanation of this strategy
All I got is a strategy with 3 options, but what’s the main purpose of it?
The main purpose of a seagull is to approximate the payoff of a single option, or a bull or bear spread, but less expensively. For example, a long bullish seagull (which the curriculum calls a long seagull) has a payoff similar to a long call (or a protective put) – guaranteed downside protection, unlimited upside – but it is less expensive. To get the lower price, you sell off some (but not all) of the upside.
you know what i am confused about is when you say bull or bear spread.
Are we assuming bear call spread or bear put spread and the same for bull spread. Are we assuming bull call or bear put spread or is it n’importe quoi as long as it reduces the cost ?
It doesn’t matter. When they say something about a bear spread, it’s true for each. Profit, delta, gamma, theta, vega, rho, breakeven, whatever: they’re the same whether it’s a call spread or a put spread.
Similarly, when they say something about a bull spread, it’s true for a bull call spread and for a bull put spread.
Of course, there are some things true for a call spread that aren’t true for a put spread, and vice-versa (e.g., payoff, initial cost). When that’s the case, they’ll specify which spread they mean.
so let me see if i understood because the goal of a seagull spread is to replicate the payoff of another option but at a much cheaper price right?
That’s all it does?