108156.pdf

9. Financial Engineering 207

5.Combination of Options and Forward Contracts.Finally, let us inves-

tigate what happens if the company hedges with both kinds of derivatives.

Half of their position will be hedged with options. In the worst case sce-

nario they will buy pounds for half of their dollar revenue at the rate of

1 .6 dollars to a pound, the remaining half being exchanged at the forward

rate of 1.5527 dollars to a pound. The outcome is shown below, where we

summarise the resulting VaR for all strategies considered (the result below

is equal to minus VaR):

strategy 1 2 3 4 5

result − 431 ,818 471, 852 − 27 , 328 − 229 ,573 222, 263

These values are computed at 95% confidence level, corresponding to the

exchange rate of 1.9887 dollars to a pound.

Clearly, VaR provides only partial information about possible outcomes of
various strategies. Figure 9.1 shows the graphs of the final result as a function
of the exchange ratedfor each of the above strategies. The graphs are labelled
by the strategy number as above. The strategy using a forward contract (strat-

Figure 9.1 Comparison of various strategies

egy 2) appears to be the safest one. An adventurous investor who strongly
believes that the pound will weaken considerably may prefer to remain uncov-
ered (strategy 1). A variety of middle-of-the-road strategies are also available.
The probability distribution of the exchange ratedshould also be taken into
account when examining the graphs.