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Article
Publication date: 1 April 1991

Jeff Madura, Alan L. Tucker and Emilio Zarruk

Since the early 1980s, currency options have become a popular means for hedging foreign currency positions or speculating on anticipated movements in exchange rates. Yet…

Abstract

Since the early 1980s, currency options have become a popular means for hedging foreign currency positions or speculating on anticipated movements in exchange rates. Yet, they can also be used to enhance the forecasting of exchange rates. Corporate forecasts of exchange rates involve two tasks: (1) a point estimate of a currency's exchange rate, and (2) a confidence interval that suggests the degree of uncertainty associated with the point estimate forecast. A currency forward or futures price is often used as the point estimate required. The confidence interval is commonly developed by using the historical volatility of exchange rate movements. However, an alternative method is to use the market's anticipated volatility in developing the confidence interval. Scott and Tucker (1990) have shown that the volatility implied from contemporaneous currency option prices is a better forecast of future volatility than historical measures. Therefore, a confidence interval implied by currency options should also be more reliable. Our objective is to illustrate how confidence intervals can be developed from currency option information. Given the degree of difficulty in forecasting exchange rates, more reliable confidence intervals could greatly improve managerial decisions.

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Managerial Finance, vol. 17 no. 4
Type: Research Article
ISSN: 0307-4358

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Article
Publication date: 7 August 2007

Raimond Maurer and Shohreh Valiani

This study seeks to examine the effectiveness of controlling the currency risk for international diversified mixed‐asset portfolios via two different hedge instruments…

Abstract

Purpose

This study seeks to examine the effectiveness of controlling the currency risk for international diversified mixed‐asset portfolios via two different hedge instruments, currency forwards and currency options. So far, currency forward has been the most common hedge tool, which will be compared here with currency options to control the foreign currency exposure risk. In this regard, several hedging strategies are evaluated and compared with one another.

Design/methodology/approach

Owing to the highly skewed return distributions of options, the application of the traditional mean‐variance framework for portfolio optimization is doubtful. To account for this problem, a mean lower partial moment model is employed. An in‐the‐sample as well as an out‐of‐the sample context is used. With in‐sample analyses, a block bootstrap test has been used to statistically test the existence of any significant performance improvement. Following that, to investigate the consistency of the results, the out‐of‐sample evaluation has been checked. In addition, currency trends are also taken into account to test the time‐trend dependence of currency movements and, therefore, the relative potential gains of risk‐controlling strategies.

Findings

Results show that European put‐in‐the‐money options have the potential to substitute the optimally forward‐hedged portfolios. Considering the composition of the portfolio in using in‐the‐money options and forwards shows that using any of these hedge tools brings a much more diversified selection of stock and bond markets than no hedging strategy. The optimal option weights imply that a put‐in‐the‐money option strategy is more active than at‐the‐money or out‐of‐the‐money put options, which implies the dependency of put strategies on the level of strike price. A very interesting point is that, just by dedicating a very small part of the investment in options, the same amount of currency risk exposure can be hedged as when one uses the optimal forward hedging. In the out‐of‐sample study, the optimally forward‐hedged strategy generally presents a much better performance than any types of put policies.

Practical implications

The research shows the risk and return implications of different currency hedging strategies. The finding could be of interest for asset managers of internationally diversified portfolios.

Originality/value

Considering the findings in the out‐of‐sample perspective, the optimally forward‐hedged minimum risk portfolio dominates all other strategies, while, in the depreciation of the local currency, this, together with the forward‐hedged tangency portfolio selection, would characterize the dominant portfolio strategies.

Details

Managerial Finance, vol. 33 no. 9
Type: Research Article
ISSN: 0307-4358

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Article
Publication date: 11 March 2006

Kashi Khazeh and Robert C. Winder

This study compares the effectiveness of money market hedges and options hedges for both payables and receivables denominated in British pounds, German marks, Japanese yen…

Abstract

This study compares the effectiveness of money market hedges and options hedges for both payables and receivables denominated in British pounds, German marks, Japanese yen and the Swiss franc. Data on interest rates, exchange rates, and options contracts were obtained from public sources for two recent time periods. This information was used to determine, for each currency: 1) the lowest rate of exchange for payables, and 2) the highest rate of exchange for receivables for each hedging technique. Unique “money market hedge exchange rate factors” and “options hedge exchange rate factors” were developed to facilitate comparisons between the two hedging techniques.

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Multinational Business Review, vol. 14 no. 1
Type: Research Article
ISSN: 1525-383X

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Article
Publication date: 1 April 1995

Andrea L. DeMaskey

Exposure risk managers can hedge exchange rate risk with either currency futures or currency options. It is generally suggested that hedgers should choose a hedge…

Abstract

Exposure risk managers can hedge exchange rate risk with either currency futures or currency options. It is generally suggested that hedgers should choose a hedge instrument that matches the risk profile of the underlying currency position as closely as possible. This advice, however, ignores the possibility that the hedging effectiveness may differ for the alternate risk management tools. This study compares the effectiveness of currency futures and currency options as hedging instruments for covered and uncovered currency positions. Based on Ederington's portfolio theory of hedging, the results show that currency futures provide the more effective covered hedge, while currency options (used to construct a synthetic futures contract) are more effective for an uncovered hedge. Hence, exposure risk managers do not have to sacrifice hedging effectiveness to obtain the desired risk profile. Corporations engaged in international business transactions are commonly exposed to exchange rate risk. Since management is concerned with currency exposure, it can hedge the anticipated exchange rate risk either with futures or options. The choice of the appropriate hedging tool is generally influenced by the type of currency exposure (transaction, translation, or economic risk), the size of the firm, the industry effect, the risk preference of the manager or the firm and his/her familiarity with the available financial instruments and techniques. It is also suggested that a hedger should choose a hedge instrument that matches the risk profile of the underlying currency position as closely as possible. Hence, futures contracts are more suitable for covered hedges, while option contracts are best used for uncovered hedges. Hedging effectiveness of these two hedge instruments must be considered as well in order to evaluate the cost of obtaining the desired risk profile. Some empirical research has shown that the futures contract provides both an appropriate risk profile and a more effective hedge than an options contract for covered positions. If these findings also hold for uncovered currency positions, then the hedging decision involves a trade‐off between the desired risk profile and hedging effectiveness. That is, a hedger would have to decide whether the extra risk protection afforded by the attractive risk profile of options is worth the loss in hedging performance. This study compares the hedging effectiveness of currency futures and currency options for both covered and uncovered positions. Ederington's risk‐minimizing approach is applied to estimate the hedging effectiveness and the least risk hedge ratios which, in turn, are used to assess the trade‐off between risk profile and hedging performance.

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Managerial Finance, vol. 21 no. 4
Type: Research Article
ISSN: 0307-4358

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Article
Publication date: 1 March 1992

M. Glaum and P.A. Belk

This paper reports the results of an empirical study undertaken during 1988 into firstly the opinions of corporate treasurers in UK multinational corporations on the…

Abstract

This paper reports the results of an empirical study undertaken during 1988 into firstly the opinions of corporate treasurers in UK multinational corporations on the process of financial innovation and the relationship between the corporates and their banks in the context of this process, and secondly the use of financial innovations in the MNCs' management of foreign exchange risk. It concludes that in general treasurers were sceptical about financial innovations, and that the relationship between the corporates and their banks appeared to be going through a difficult phase reflecting the breaking up of traditional links between banks and their corporate customers. The findings on the use of financial innovations varied; while currency futures were not used at all by the MNCs, the treasurers tried out the use of currency options and swaps. A general conclusion was that the corporates' exchange risk management practices were short term orientated and innovations were incorporated into the day‐to‐day management of positions rather than into longer term strategic decisions.

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Managerial Finance, vol. 18 no. 3
Type: Research Article
ISSN: 0307-4358

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Article
Publication date: 1 July 2000

Orapin Duangploy and Dahli Helmi

Auditors nowadays must be aggressive and involved in risk assessment and analysis. This paper identifies, analyzes, and recommends a solution to a current problem in…

Abstract

Auditors nowadays must be aggressive and involved in risk assessment and analysis. This paper identifies, analyzes, and recommends a solution to a current problem in accounting for foreign‐currency hedges. This is accomplished by an examination of the Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivatives Instruments and Hedging Activities, as issued in June 1998. Multi‐currency accounting is recommended as an alternative to functional‐currency accounting. The information generated by the multi‐currency versus the functional currency (as advocated in the SFAS 133) accounting methods for using options as hedging instruments is illustrated. Multi‐currency accounting excels in its transparency. It more clearly provides information on the respective exposure positions of the hedged items and the hedging instruments as well as the notional amounts. Auditors’ risk assessment and analysis can now be effectively performed under this system.

Details

Managerial Auditing Journal, vol. 15 no. 5
Type: Research Article
ISSN: 0268-6902

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Book part
Publication date: 28 October 2019

Angelo Corelli

Abstract

Details

Understanding Financial Risk Management, Second Edition
Type: Book
ISBN: 978-1-78973-794-3

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Article
Publication date: 1 March 1990

Hung‐Gay Fung, Chin‐Jen Lie and Abel Moreno

This study evaluates the forecasting performance of different predictive measures for the future exchange rate variability. Results seem to indicate that the…

Abstract

This study evaluates the forecasting performance of different predictive measures for the future exchange rate variability. Results seem to indicate that the out‐of‐the‐money ISD outperforms the at‐the‐money ISD and other predictive measures. Thus, when ISD is used to forecast future exchange rate variability, out‐of‐the‐money options should be selected instead of using all other options to compute the complicated weighting schemes.

Details

Managerial Finance, vol. 16 no. 3
Type: Research Article
ISSN: 0307-4358

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Article
Publication date: 5 September 2019

Aparna Prasad Bhat

The purpose of this paper is to examine whether volatility implied from dollar-rupee options is an unbiased and efficient predictor of ex post volatility, and to determine…

Abstract

Purpose

The purpose of this paper is to examine whether volatility implied from dollar-rupee options is an unbiased and efficient predictor of ex post volatility, and to determine which options market is a better predictor of future realized volatility and to ascertain whether the model-free measure of implied volatility outperforms the traditional measure derived from the Black–Scholes–Merton model.

Design/methodology/approach

The information content of exchange-traded implied volatility and that of quoted implied volatility for OTC options is compared with that of historical volatility and a GARCH(1, 1)-based volatility. Ordinary least squares regression is used to examine the unbiasedness and informational efficiency of implied volatility. Robustness of the results is tested by using two specifications of implied volatility and realized volatility and comparison across two markets.

Findings

Implied volatility from both OTC and exchange-traded options is found to contain significant information for predicting ex post volatility, but is neither unbiased nor informationally efficient. The implied volatility of at-the-money options derived using the Black–Scholes–Merton model is found to outperform the model-free implied volatility (MFIV) across both markets. MFIV from OTC options is found to be a better predictor of realized volatility than MFIV from exchange-traded options.

Practical implications

This study throws light on the predictive power of currency options in India and has strong practical implications for market practitioners. Efficient currency option markets can serve as effective vehicles both for hedging and speculation and can convey useful information to the regulators regarding the market participants’ expectations of future volatility.

Originality/value

This study is a comprehensive study of the informational efficiency of options on an emerging currency such as the Indian rupee. To the author’s knowledge, this is one of the first studies to compare the predictive ability of the exchange-traded and OTC markets and also to compare traditional model-dependent volatility with MFIV.

Details

Managerial Finance, vol. 45 no. 9
Type: Research Article
ISSN: 0307-4358

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Article
Publication date: 8 October 2018

Aparna Prasad Bhat

The purpose of this paper is to ascertain the effectiveness of major deterministic and stochastic volatility-based option pricing models in pricing and hedging…

Abstract

Purpose

The purpose of this paper is to ascertain the effectiveness of major deterministic and stochastic volatility-based option pricing models in pricing and hedging exchange-traded dollar–rupee options over a five-year period since the launch of these options in India.

Design/methodology/approach

The paper examines the pricing and hedging performance of five different models, namely, the Black–Scholes–Merton model (BSM), skewness- and kurtosis-adjusted BSM, NGARCH model of Duan, Heston’s stochastic volatility model and an ad hoc Black–Scholes (AHBS) model. Risk-neutral structural parameters are extracted by calibrating each model to the prices of traded dollar–rupee call options. These parameters are used to generate out-of-sample model option prices and to construct a delta-neutral hedge for a short option position. Out-of-sample pricing errors and hedging errors are compared to identify the best-performing model. Robustness is tested by comparing the performance of all models separately over turbulent and tranquil periods.

Findings

The study finds that relatively simpler models fare better than more mathematically complex models in pricing and hedging dollar–rupee options during the sample period. This superior performance is observed to persist even when comparisons are made separately over volatile periods and tranquil periods. However the more sophisticated models reveal a lower moneyness-maturity bias as compared to the BSM model.

Practical implications

The study concludes that incorporation of skewness and kurtosis in the BSM model as well as the practitioners’ approach of using a moneyness-maturity-based volatility within the BSM model (AHBS model) results in better pricing and hedging effectiveness for dollar–rupee options. This conclusion has strong practical implications for market practitioners, hedgers and regulators in the light of increased volatility in the dollar–rupee pair.

Originality/value

Existing literature on this topic has largely centered around either US equity index options or options on major liquid currencies. While many studies have solely focused on the pricing performance of option pricing models, this paper examines both the pricing and hedging performance of competing models in the context of Indian currency options. Robustness of findings is tested by comparing model performance across periods of stress and tranquility. To the best of the author’s knowledge, this paper is one of the first comprehensive studies to focus on an emerging market currency pair such as the dollar–rupee.

Details

Journal of Indian Business Research, vol. 11 no. 1
Type: Research Article
ISSN: 1755-4195

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