Hedge #2 : A short position of EUR8,000,000 coming due on a HKD/EUR forward contract. The market value of the EUR-denominated assets has increased (measured in EUR). Yang expects the HKD/EUR spot rate to depreciate.
HKD/EUR
10.0200/10.0210
My question is related to the spot leg of the transaction, and why the ask is not being used when Yang is buying. There is an explanation attached but I do not really understand it. The spot leg of the swap—buying back EUR8,000,000 to settle the outstanding forward transaction—is also based on the bid rate of 10.0200. This is because Yang is selling an amount larger than EUR 8,000,000 forward, and the all-in forward rate of the swap is already using the bid side of the market (as it would for a matched swap). Hence, to pick up the net increase in forward EUR sales, the dealer Yang is transacting with would price the swap so that Yang also has to use bid side of the spot quote for the spot transaction used to settle the maturing forward contract.
Could someone please explain more in detail why the bid side is being used?
You are short the EUR, you have to deliver (sell) the Euro at maturity. If you are Selling, the dealer is buying hence why you use the Dealer’s bid quote.
Yes she is short, but I am talking about the amount she is buying back (the spot transaction). She rolls forward and shorts, for that transaction she uses the bid, however when she settles the current forward she has to buy spot. My question is why do we not use ASK for the buy spot transaction? We now use bid for sale forward and buying spot.
I too am confused. My understanding is that it would be using midpoint quote convention for a matched swap. This is obviously not a matched swap. Her short position has lost value to her ( eur appreciated and she is short the eur). Assuming that the current position is hypothetically worth 8,500,000 now vs 8,000,000 - she would need to Buy back more than she is selling forward. These problems have given me heartburn since the beginning of my study endeavors!
the ASSET in EUR has appreciated so she needs to INCREASE her hedge and SELL more EUR forward to hedge the asset. It doesnt say the EUR currency appreciated it says the asset appreciated. So, she needs to sell eur forward at the bid. We are always concerned with the NET of the transaction. the net is selling more forward? does this make sense?
I think magic2000 has a nice trick to this - compute the least adv position opposite to the dealer and that will be the quote
in this case, Yang wants to sell euros quote:hkd/ eur
to roll her hedge, she buys back near leg and sells larger, far leg i.e., netseller - so she should receive fewer hkd - min ( 10.20 /10.21) + min ( 125 /135) pips.
We can apply the same situation to the first case in the same blue box:
In this yen case, Quote: yen /hkd- she wants to sell yen or buy hkd - but she wants matched (neutral=buy and sell ¥800m - she gets to use mid quote *.
to roll her hedge, she needs to pay moreyen i.e., max( 10.80/10.82 )* + max(-20/-14) pips.
Hope did not add to the confusion, appreciate input/corrections