Hedging Strategy Framework and Comparison
5 minutes reading
Common Hedging Strategies
When it comes to managing financial risk, particularly in the realm of currency exchange, choosing the right hedging strategy is crucial. Here's a structured approach to identify and implement the most effective hedging strategies.
Common Hedging Strategies - Key Criteria
Forward Contract (FWD)
A forward contract is a customized financial agreement between two parties to buy or sell an asset, such as a currency, at a specified future date for a price agreed upon today. Unlike standardized contracts, forward contracts offer flexibility but also carry counterparty risk.
Deaglo Tool to Check Performance
- FWD Efficiency: Quantify the annualized carry of this strategy.
- Optimize the Tenor: Adjust the contract duration for optimal performance.
- Probability Analysis: Calculate the likelihood of the forward contract expiring in the money.
Vanilla Call Option
A vanilla call option gives the holder the right, but not the obligation, to buy an asset at a predetermined price (strike price) within a specified period. If the market price exceeds the strike price, the holder can exercise the option for a profit. This straightforward option type is widely used.
Collar Strategy
A collar strategy involves holding a position in the underlying asset while buying a protective put option (to limit downside risk) and selling a call option (to limit upside potential). This strategy effectively "collars" the price range within which the asset can move, reducing both potential losses and gains.
Seagull Option Strategy
A seagull option strategy is a three-legged approach involving the purchase of a put option, the sale of a call option at a higher strike price, and the sale of another put option at a lower strike price. This strategy limits both downside and upside potential within a certain range, reducing the cost of hedging while providing limited protection.
To effectively compare different hedging strategies, consider the following criteria:
1 - Payoff Diagrams
Payoff diagrams provide a visual representation of potential outcomes for each strategy based on different realized spot prices. These diagrams help to understand the risk and reward profiles of each strategy.
2 - Cost Analysis
Evaluate the costs associated with each strategy, including premiums for options, transaction costs, and any other associated fees.
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