FINANCE UNIVERSITY UNDER THE GOVERNMENT

OF THE RUSSIAN FEDERATION

INTERNATIONAL ECONOMIC RELATIONS FACULTY

ECONOMIC THEORY DEPARTMENT

THE PRACTICAL WORK

ON THE DISCIPLINE

“INTERNATIONAL FINANCE”

« Application of derivative financial instruments to manage

market risk in the global foreign exchange market by banks»

Written by:
Romanov M.A.
student of IFF 21-2 group

Scientific adviser:
Sakharov D.M.

Moscow 2024
 List of Content:

I. Introduction pp. 3 – 4
II. Theoretical Framework and Application of Derivatives
 Definition and types of market risk pp. 5 – 6
 Forwards and Futures pp. 6 – 7
 Options pp. 7 – 8
 Swaps pp. 8 – 9
 How banks use derivative to hedge pp. 9 – 14
III. Case Study: Bear Spread Strategy pp 15 – 24
IV. Conclusion pp. 25 - 27
V. List of References pp. 28 – 29

2
 I. Introduction

The global financial landscape is a complex and dynamic arena where the
constant flux of currencies forms the backbone of international trade and
economic activities. At the heart of this landscape lies the global foreign
exchange market, a decentralized and vast network where currencies are traded
around the clock. This market is not only a barometer of global economic health
but also a field where various financial actors, especially banks, engage in a
perpetual balancing act of risk and reward. The application of derivative
financial instruments has become a sophisticated method employed by these
institutions to manage and mitigate market risks that arise from the inherent
volatility of currency values.
The global foreign exchange market, colloquially known as Forex or FX,
is the world’s largest financial market, dwarfing the stock market in terms of
volume and liquidity. With a daily turnover that surpasses 6 trillion USD, it is
the epitome of global financial activity. The market facilitates the exchange of
currencies for a multitude of purposes, including but not limited to, international
trade, investment, tourism, and hedging activities. The participants range from
central banks, commercial banks, financial institutions, corporatiЧ]ons,
governments, and retail investors, each interacting in a web of complex
financial transactions.
The Forex market operates on a 24-hour basis, segmented into various
sessions that correspond to the business hours of major financial centers across
different time zones. This continuous operation ensures that the market is
responsive to any economic event at any time, making it a highly sensitive and
reactive ecosystem. The currencies are traded in pairs, with the exchange rates
being determined by a multitude of factors, including interest rates, economic
indicators, political stability, and market sentiment.

3
 Market risk, also known as systematic risk, refers to the potential for
investors to experience losses due to factors that affect the overall performance
of the financial markets. In the context of the foreign exchange market, this risk
is predominantly manifested through currency fluctuations, which can be
precipitated by changes in macroeconomic variables, geopolitical tensions, and
unexpected financial events. The implications of these fluctuations are
profound, as they can lead to significant financial losses for market participants,
particularly those with large exposure to foreign currencies.
For banks and financial institutions, managing market risk is not just a
matter of protecting their financial assets; it is also about preserving client trust,
maintaining market stability, and ensuring the smooth functioning against
unfavorable currency movements. These instruments allow banks to lock in
exchange rates, control interest rate exposure, and manage cash flow
uncertainties. Derivatives also enable banks to speculate on future market
trends, providing an opportunity to profit from predicted movements in
currency values.
Forwards and futures are contractual agreements to buy or sell a specific
amount of currency at a predetermined price on a set date in the future. These
instruments are commonly used by banks to hedge against the risk of currency
fluctuations by locking in exchange rates for future transactions.
Options give the holder the right, but not the obligation, to buy or sell
currency at a specified price within a certain time frame. This flexibility allows
banks to manage risk while still being able to benefit from favorable market
movements.
Swaps involve exchanging one set of cash flows for another and are often used
to manage interest rate risk or to gain exposure to different currencies without
the need for physical exchange.

4
 II. Theoretical Framework and Application of Derivatives

Definition and types of market risks: interest rate risk, currency risk,
credit risk, and commodity risk.
Market risk, also known as systematic risk, is the potential for investors
to experience losses due to factors that affect the overall performance of
financial markets. These risks are inherent to investing and are largely
unpredictable, as they stem from changes in economic conditions, political
events, and market sentiment. Market risk encompasses various types, including
interest rate risk, which arises from fluctuations in interest rates that can affect
the value of financial instruments. A real-world instance of this is the collapse
of Silicon Valley Bank, where the bank faced significant losses due to the
plummeting values of long-term bonds as interest rates rose. Currency risk, or
exchange rate risk, occurs when the value of investments fluctuates due to
changes in currency exchange rates, such as a U.S. investor holding stocks in
Canada being affected by the depreciation of the Canadian dollar against the
U.S. dollar. Credit risk involves the possibility that a borrower will default on
their financial obligations, exemplified by credit card debt defaults posing a risk
to issuers if the debts are not repaid. Lastly, commodity risk is associated with
the price volatility of raw materials, like automobile manufacturers facing
commodity risk as they rely on steel and rubber; fluctuations in these
commodities' prices can significantly impact their profit margins.

The Federal Reserve's rate hikes in 2022 led to a revaluation of long-term

bonds, impacting financial institutions holding these assets. During the 1997
Asian currency crisis, the devaluation of the Thai baht had widespread effects
on investors and businesses with exposure to the region's currencies. The global
financial crisis of 2008 is a stark reminder of credit risk, where the default on

5
mortgage-backed securities led to a systemic collapse. The oil price shock of
2014-2016 saw a dramatic drop in oil prices, affecting producers and countries
reliant on oil revenues. Understanding these risks is crucial for banks as they
navigate the global foreign exchange market, allowing them to protect their
investments and ensure financial stability.

Forwards and Futures: Used by banks to lock in an exchange rate or

interest rate, helping to manage currency and interest rate risks.
In the realm of international finance, banks employ various derivative
instruments to hedge against market risks, and among these, forwards and
futures are pivotal in managing currency and interest rate fluctuations. Forwards
are customized contracts negotiated over the counter, where two parties agree to
buy or sell an asset at a predetermined price at a future date. These contracts are
tailored to the specific needs of the contracting parties, allowing for flexibility
in terms of the asset amount and delivery date. However, this customization
comes with increased counterparty risk, as the contracts are not standardized
and lack the regulatory oversight of exchange-traded instruments.
Futures, on the other hand, are standardized contracts that are traded on
exchanges. These contracts are marked to market daily, which means that gains
and losses are settled every day until the contract expires. This daily settlement
reduces the counterparty risk significantly, as the exchange acts as the
intermediary, guaranteeing the fulfillment of the contract terms.
Banks utilize these instruments to lock in exchange rates or interest rates, thus
mitigating the risk of adverse movements in these rates. For example, if a bank
expects to receive a payment in a foreign currency, it might enter into a forward
contract to sell the expected foreign currency amount at a fixed exchange rate,
thereby eliminating the uncertainty of currency fluctuations. Similarly, if a bank
has issued a variable-rate loan but wants to ensure a fixed rate of return, it might

6
enter into an interest rate swap or a futures contract to hedge against the risk of
interest rate increases.
Real-life examples of banks using forwards and futures include instances
where financial institutions hedge their exposure to commodity prices or foreign
currencies. For instance, during the European debt crisis, banks used currency
forwards to protect against the volatility of the Euro. In another case, a bank
anticipating a rise in interest rates might use interest rate futures to lock in lower
rates for its loans.
These derivative instruments are essential tools for banks, allowing them
to manage the risks associated with changes in market conditions effectively.
By employing forwards and futures, banks can stabilize their financial
operations and maintain profitability despite the inherent uncertainties of the
global foreign exchange market.

Options: Provide banks with the right, but not the obligation, to buy or sell
an asset at a predetermined price, offering a way to hedge against adverse
price movements while allowing participation in favorable movements.
Options are a class of derivative financial instruments that banks use
extensively to manage market risks. They provide the buyer with the right, but
not the obligation, to buy (call option) or sell (put option) an underlying asset at
a predetermined price within a specific timeframe. This characteristic of options
allows banks to hedge against adverse price movements while retaining the
ability to benefit from favorable price changes.

In the banking sector, options are employed as a strategic tool for risk
management. For instance, a bank expecting to receive a large payment in a
foreign currency may purchase a put option to sell the expected amount at a
fixed exchange rate, thereby hedging against the risk of currency depreciation.
Conversely, if a bank has an obligation to make a payment in a foreign

7
currency, it might buy a call option to ensure it can make the payment at a
known rate, protecting itself against currency appreciation.
The versatility of options extends to their use in managing interest rate
risks. Banks can use options to secure borrowing costs by obtaining the right to
borrow at a certain interest rate in the future, thus guarding against the risk of
rising rates. Similarly, they can protect against falling interest rates on assets
that generate interest income by purchasing options that allow them to receive
payments if rates decrease.
Some of the examples of banks using options include scenarios where
financial institutions have protected their loan portfolios from fluctuating
interest rates. During periods of financial uncertainty, such as the economic
downturns, banks have utilized options to stabilize their operations and maintain
profitability. Another example is the use of options by banks during the oil price
volatility, where options contracts were used to hedge against the price
fluctuations of commodities that impact the banks' investment portfolios.
Options play a critical role in the banking industry's risk management
strategies, offering a flexible and effective means to navigate the complexities
of the global foreign exchange market. Their ability to limit downside risk while
allowing participation in potential upside gains makes them an invaluable tool
for banks worldwide.

Swaps: Interest rate swaps and currency swaps are commonly used to
manage interest rate fluctuations and to hedge against exchange rate
volatility.
Swaps are sophisticated financial instruments that banks leverage to
manage various types of market risks, particularly interest rate and currency
risks. A swap is a derivative contract through which two parties exchange
financial obligations from different financial instruments. The most common
swaps are interest rate swaps and currency swaps.

8
 In an interest rate swap, banks exchange cash flows based on a notional
principal amount, typically involving one party paying a fixed interest rate and
receiving a variable rate in return. This allows banks to hedge against the risk of
fluctuating interest rates. For example, a bank might enter into an interest rate
swap to transform the interest payments on a variable-rate loan to fixed
payments, thereby stabilizing its cash flows and managing its interest rate
exposure.
Currency swaps involve exchanging principal and interest payments in
one currency for equivalent amounts in another currency. This helps banks
manage the risk associated with currency fluctuations. For instance, if a bank
has liabilities in a foreign currency that it expects to appreciate, it might enter
into a currency swap to fix the cost of those liabilities in its home currency, thus
protecting itself from the risk of currency appreciation.
Real-world examples of banks using swaps include cases where they have
sought to stabilize their funding costs or hedge against potential losses from
interest rate movements. During the financial crisis, many banks used interest
rate swaps to manage the volatility of their interest income and expenses.
Similarly, currency swaps have been employed by banks to secure the value of
their international investments and obligations.
By using swaps, banks can effectively manage their financial risks and
ensure stability in their operations. These instruments play a crucial role in the
global financial system, providing banks with the means to mitigate the risks
associated with changes in interest rates and currency values.

Banks use derivatives to hedge against potential losses in their asset

portfolios and to stabilize earnings.
In the dynamic landscape of international finance, banks frequently
utilize derivatives as a strategic tool for risk management. Derivatives, such as

9
options, futures, forwards, and swaps, are contracts whose value is derived from
the performance of underlying financial assets, indexes, or other instruments.
By engaging in these contracts, banks can effectively hedge against potential
losses in their asset portfolios and stabilize their earnings.
Hedging is a risk management strategy employed by banks to offset
potential losses in one position by taking another. For example, if a bank holds a
significant amount of a particular stock, it might purchase put options for that
stock. These options give the bank the right to sell the stock at a predetermined
price, thus setting a floor for potential losses. The cost of this protection is the
premium paid for the options.
Derivatives also play a crucial role in stabilizing a bank's earnings.
Interest rate swaps, for instance, can be used to convert variable-rate debt into
fixed-rate debt. This swap helps the bank manage the uncertainty of fluctuating
interest payments, leading to more predictable financial outcomes.
Consider a bank that has a loan portfolio with a significant exposure to
variable interest rates. To hedge against the risk of rising interest rates, the bank
enters into an interest rate swap agreement. In this swap, the bank agrees to pay
a fixed rate to a counterparty while receiving a variable rate in return. The fixed
rate is set at 3%, and the variable rate is tied to the LIBOR (London Interbank
Offered Rate), which is currently at 2.5%.

The swap can be represented by the following equation:

Net Swap Payment = Notional Principal × (LIBOR - Fixed Rate)

If LIBOR rises to 3.5%, the bank will receive payments, which can be
calculated as:

Net Swap Payment = $100,000,000 × (3.5% - 3%) = $500,000

10
This payment compensates for the increased interest payments the bank must
make on its variable-rate loans, thus stabilizing its earnings.

Derivatives allow banks to transfer risks to other market participants

willing to take on those risks.
In the intricate web of financial markets, derivatives serve as a conduit
for transferring risks from entities less willing or able to manage them to those
more inclined or better positioned to do so. Banks, in particular, utilize
derivatives to transfer various types of risks inherent in their asset portfolios,
thereby safeguarding their financial stability and earnings.
Derivatives such as credit default swaps (CDS), options, and futures contracts
enable banks to transfer specific risks to other market participants. For instance,
a bank concerned about a borrower's creditworthiness might use a CDS to
transfer the credit risk to another party. In exchange for a fee, the CDS seller
agrees to compensate the bank if the borrower defaults, effectively taking on the
credit risk.
A practical example of risk transfer using derivatives is the case of JPMorgan
Chase & Co. during the financial crisis of 2008. The bank used credit default
swaps to transfer the risk of mortgage-backed securities (MBS) defaulting. By
paying a premium to the CDS sellers, JPMorgan was able to hedge against the
risk of significant losses from these securities.

The cost of this risk transfer can be represented by the following equation:

CDS Premium = Notional Amount × CDS Spread

If the notional amount of the MBS is $100 million and the CDS spread is 100
basis points, the annual premium paid by the bank would be:

11
 CDS Premium = $100,000,000 × 1% = $1,000,000

This premium reflects the cost of transferring the credit risk of the MBS from
the bank to the CDS seller.

Interest Rate-Based Derivatives: Play a crucial role in managing financial

risk, with futures and options serving the needs of lenders, borrowers, and
investors
Interest rate-based derivatives are pivotal instruments in the financial
toolkit of banks, serving as protection against fluctuations in interest rates.
These derivatives, which include futures, options, swaps, and other related
contracts, are ingeniously designed to provide banks with the means to manage
the risks associated with lending, borrowing, and investing activities.
The essence of these derivatives lies in their ability to lock in interest rates or to
bet on their future movements. For example, an interest rate swap allows a bank
with a floating-rate loan to exchange its cash flows with another party that has a
fixed-rate loan. This swap can effectively transform the bank's variable interest
obligations into fixed ones, thereby insulating it from the risk of rising interest
rates.
A practical instance of this is when a bank anticipates an increase in
interest rates, which could potentially erode the value of its fixed-income
portfolio. To hedge against this risk, the bank might purchase interest rate
futures. These futures contracts would gain in value as interest rates rise,
offsetting the losses in the bank's bond portfolio.

The potential gain or loss from such a futures contract can be calculated using
the following formula:

12
 Gain/Loss = Number of Contracts × Contract Size × (New Interest Rate -
Original Interest Rate)

If the bank buys 10 futures contracts with a contract size of \$100,000 each, and
the interest rate increases by 0.5%, the gain can be computed as:

Gain = 10 × $100,000 × 0.5% = $5,000

This gain helps to counterbalance the decrease in the bank's bond portfolio
value due to the rising interest rates.

Risk Mitigation: Derivatives are used to mitigate risks associated with

adverse moves in asset prices, protecting investments and portfolios.
The use of derivatives for risk mitigation involves creating a hedge that
counterbalances potential losses. For example, if a bank holds a portfolio of
stocks that it believes might decrease in value due to market volatility, it can
purchase put options on those stocks. These options grant the bank the right to
sell the stocks at a predetermined price, thus capping the potential losses.
A practical example of risk mitigation using derivatives is when a bank
anticipates a downturn in the real estate market. To protect its real estate
investment trust (REIT) holdings, the bank might buy put options on a REIT
index. If the index falls below the strike price of the options, the bank can
exercise the options and sell the index at the higher strike price, thereby
mitigating its losses.
The effectiveness of this hedge can be quantified using the following formula:

Hedge Effectiveness = Hedged Position Value - Unhedged Position Value

Hedged Position Value

13
If the unhedged REIT index value falls from $100 to $80, but the hedged
position remains at $100 due to the put options, the hedge effectiveness can be
calculated as:

Hedge Effectiveness = $100 000 - $87 000 $100 000= 13%

This 13% represents the portion of the portfolio's value that was protected due
to the hedge.

14
 III. Case Study: Bear Spread Strategy

In the intricate world of global finance, banks are continuously exposed to

various forms of market risks, one of the most significant being foreign
exchange (FX) risk. This risk arises from the volatility in currency exchange
rates, which can impact the bank’s assets, liabilities, and overall financial
performance. To mitigate these risks, banks employ a variety of derivative
financial instruments, with options being a prominent choice due to their
flexibility and capacity to hedge against adverse market movements.

The Bear Spread strategy, specifically utilizing put options, presents a

structured approach to managing potential declines in currency values. This
case study explores the practical application of the Bear Spread strategy within
the context of the USD/GBP currency pair, a critical exchange rate for
international banking operations. The focus is on how a bank might leverage
this strategy to protect against a forecasted depreciation of the USD relative to
the GBP.

Scenario Description

Consider a scenario where a multinational bank, with significant USD

holdings, anticipates a short-term economic event that could weaken the USD
against the GBP. The bank’s treasury department, aiming to safeguard its
balance sheet from the expected downward trend, decides to implement a Bear
Spread strategy. By purchasing put options with a higher strike price and
simultaneously selling put options with a lower strike price, the bank creates a
position that benefits from the USD’s decline while limiting potential losses.

Setting Description

15
 The Bear Spread is executed in a controlled manner, where the bank’s
risk management team carefully selects the strike prices and expiration dates of
the options to align with their market outlook and risk appetite. The Black-
Scholes model is employed to price these options, taking into account the
current exchange rate, the anticipated volatility, and the time horizon of the
bank’s exposure to the FX risk.

This case study will delve into the calculations behind the Black-Scholes
model, demonstrating how it informs the bank’s strategic decisions in
constructing the Bear Spread. Through this analysis, we aim to illustrate the
efficacy of derivative financial instruments in managing market risk and
highlight the critical role they play in the stability and profitability of banking
operations in the global foreign exchange market.

Understanding the Bear Spread Strategy

A Bear Spread strategy involves using two put options (or call options)
with the same expiration date but different strike prices. It is designed to profit
from a decline in the price of the underlying asset. For this example, we will use
put options.

16
Assumptions and Inputs for the Black-Scholes Model
We'll need the following inputs to price the options using the Black-Scholes
model:

1. Current Spot Price (S): Current exchange rate of USD/GBP.

2. Strike Prices (K1 and K2): The strike prices for the two put options where
K1 < K2.
3. Time to Maturity (T): The time remaining until the option's expiration, in
years.
4. Risk-free Rate (r): The risk-free interest rate, typically based on
government bonds.
5. Volatility (σ): The volatility of the underlying asset (annualized standard
deviation of log returns).

For this example, let's use the following hypothetical inputs:

 Current Spot Price (S): 1.3000 USD/GBP

 Strike Price K1: 1.2800 USD/GBP

17
  Strike Price K2: 1.3200 USD/GBP
 Time to Maturity (T): 0.5 years (6 months)
 Risk-free Rate (r): 2% per annum
 Volatility (σ): 15% per annum

3. Black-Scholes Model for Put Option Pricing

The Black-Scholes formula for a European put option is given by:

−rT
P=K e N (−d 2 ) −SN (−d1 )

Where:

d 1∧¿
( 1
)
ln ⁡(S / K )+ r + σ 2 T
2
σ √T
d 2∧¿ d 1−σ √ T

Calculation

We'll calculate the prices of two put options using the Black-Scholes model and
then determine the net payoff of the Bear Spread strategy.

Put Option with Strike Price K1 (1.2800)

Let's calculate the value of the put option with strike price K1=1.2800

ln ⁡(1.3000/1.2800)+ ( 0.02+0.5 × 0.152 ) ×0.5

¿ d 1 ,1=
0.15 √ 0.5
¿ d 2 ,1=d 1, 1−0.15 √ 0.5

Put Option with Strike Price K2 (1.3200)

Let's calculate the value of the put option with strike price K2=1.3200:

18
 ln ⁡(1.3000/1.3200)+ ( 0.02+0.5 × 0.152 ) ×0.5
¿ d 1 ,2 =
0.15 √ 0.5
¿ d 2 ,2=d 1, 2−0.15 √ 0.5

We'll use these values to find P1 and P2, the prices of the put options.

The net payoff of the Bear Spread strategy at maturity is given by:

Payoff =P 1−P 2

I calculated these values using Python.

Results

19
(0.039482744945503634, 0.05862869638708024, -0.019145951441576603)

Output

Based on the calculations using the Black-Scholes model, we have the

following results for the Bear Spread strategy using the USD/GBP pair:

1 Put Option with Strike Price K 1=1.2800 :

 Price (P1): 0.03948 USD/GBP

2 Put Option with Strike Price K 2=1.3200 :

 Price (P2): 0.05863 USD/GBP

3 Net Payoff of the Bear Spread Strategy:

 Payoff: P 1−P 2=0.03948−0.05863=−0.01915 USD/GBP

Interpretation

 The price of the put option with a lower strike price (1.2800) is 0.03948
USD/GBP.

 The price of the put option with a higher strike price (1.3200) is 0.05863
USD/GBP.

 The net payoff of the Bear Spread strategy is negative, specifically -

0.01915 USD/GBP. This suggests that in this scenario, the Bear Spread
strategy incurs a small net cost.

Scenario Analysis

20
 A Bear Spread strategy is designed to profit from a decline in the
underlying asset's price, employing two put options with different strike prices
but the same expiration date.

We consider two potential market scenarios to understand the implications of

this strategy:

1. Scenario 1: Decline in USD/GBP - Here, we assume the exchange rate

drops to 1.2500 USD/GBP at the time of the options' expiration.

2. Scenario 2: Rise in USD/GBP - In this scenario, we assume the

exchange rate increases to 1.3500 USD/GBP at expiration.

By analyzing the net payoffs under these conditions, we aim to illustrate the
potential outcomes and risks associated with implementing a Bear Spread
strategy in the foreign exchange market.

Scenario 1: Decline in USD/GBP

Let's assume that the spot price of USD/GBP declines to 1.2500 at maturity.

Scenario 2: Rise in USD/GBP

Let's assume that the spot price of USD/GBP rises to 1.3500 at maturity.

Formula for Payoff of a Put Option at Maturity

The payoff of a put option at maturity is given by:

Payoff put =max ( K−ST ,0 )

where K is the strike price and ST is the spot price at maturity.

21
Scenario 1: Decline in USD/GBP to 1.2500

 Put Option with Strike Price K 1=1.2800 :

Payoff K 1=max (1.2800−1.2500 , 0)=0.0300

 Put Option with Strike Price K 2=1.3200 :

Payoff K 2=max (1.3200−1.2500 , 0)=0.0700

 Net Payoff of Bear Spread:

Net Payoff = Payoff K 1− Payoff K 2=0.0300−0.0700=−0.0400

Scenario 2: Rise in USD/GBP to 1.3500

 Put Option with Strike Price K 1=1.2800 :

Payoff K 1=max (1.2800−1.3500 , 0)=0.0000

 Put Option with Strike Price K 2=1.3200 :

Payoff K 2=max (1.3200−1.3500 , 0)=0.0000

 Net Payoff of Bear Spread:

Net Payoff = Payoff K 1− Payoff K 2=0.0000−0.0000=0.0000

Summary of Results

Let's summarize the net payoffs for both scenarios:

1. Scenario 1: Decline in USD/GBP to 1.2500

 Net Payoff: -0.0400 USD/GBP

2. Scenario 2: Rise in USD/GBP to 1.3500

 Net Payoff: 0.0000 USD/GBP

22
Python Calculation

Results
(0.030000000000000027, 0.07000000000000006, -0.040000000000000036, 0,
0, 0)

23
Scenario Analysis Results

Based on the calculations, here are the results for the two scenarios:

Scenario 1: Decline in USD/GBP to 1.2500

 Put Option with Strike Price K1=1.2800:

 Payoff: 0.0300 USD/GBP

 Put Option with Strike Price K2=1.3200:

 Payoff: 0.0700 USD/GBP

 Net Payoff of Bear Spread:

 Net Payoff: 0.0300−0.0700=−0.04000.0300−0.0700=−0.0400

USD/GBP

Scenario 2: Rise in USD/GBP to 1.3500

 Put Option with Strike Price K1=1.2800:

 Payoff: 0.0000 USD/GBP

 Put Option with Strike Price K2=1.3200:

 Payoff: 0.0000 USD/GBP

 Net Payoff of Bear Spread:

 Net Payoff: 0.0000−0.0000=0.00000.0000−0.0000=0.0000

USD/GBP

Summary of Results

1. Scenario 1: Decline in USD/GBP to 1.2500

 The net payoff is -0.0400 USD/GBP, indicating a loss. This is

because the drop in the exchange rate didn't fall sufficiently within

24
 the spread to generate a positive payoff after accounting for the
initial cost.

2. Scenario 2: Rise in USD/GBP to 1.3500

 The net payoff is 0.0000 USD/GBP. Both options expire worthless

since the spot price at maturity is above both strike prices, resulting
in no profit or loss (other than the initial cost).

IV. Conclusion

This scenario analysis shows the outcomes of the Bear Spread strategy under
different market conditions:

 Declining Market: The Bear Spread strategy can still result in a loss if the
drop in the underlying asset's price is insufficient to offset the initial cost
of the strategy.

 Rising Market: The strategy results in no payoff since both options expire
worthless, but the initial cost is also not recouped.

Summary of Results

1. Scenario 1: Decline in USD/GBP to 1.2500

 Put Option with Strike Price K1=1.2800: Payoff = 0.0300

USD/GBP

 Put Option with Strike Price K2=1.3200: Payoff = 0.0700

USD/GBP

 Net Payoff of Bear Spread: -0.0400 USD/GBP

25
 2. Scenario 2: Rise in USD/GBP to 1.3500

 Put Option with Strike Price K1=1.2800: Payoff = 0.0000

USD/GBP

 Put Option with Strike Price K2=1.3200: Payoff = 0.0000

USD/GBP

 Net Payoff of Bear Spread: 0.0000 USD/GBP

Analysis and Implications for Banks

The Bear Spread strategy, while primarily designed to profit from a decline in
the underlying asset's price, also serves as a risk management tool for banks
dealing with foreign exchange exposures. The strategy's performance, as
observed in the scenarios, highlights the following key points:

1. Risk Mitigation in Declining Markets:

 In Scenario 1, where the USD/GBP exchange rate falls to 1.2500,

the Bear Spread strategy results in a net loss of 0.0400 USD/GBP.
This loss occurs because the drop in the exchange rate was not
sufficient to fully capitalize on the put options' potential payoff,
considering the initial cost of the strategy.

 This outcome underscores the importance of accurately forecasting

market movements and selecting appropriate strike prices. While
the strategy incurs a cost in this instance, it does provide a hedge
against more significant declines, which could be critical in volatile
market conditions.

2. Limited Upside Risk in Rising Markets:

 In Scenario 2, where the USD/GBP exchange rate rises to 1.3500,

both put options expire worthless, resulting in a net payoff of

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 0.0000 USD/GBP. The bank does not incur additional losses
beyond the initial cost of entering the Bear Spread.

 This aspect of the strategy demonstrates its ability to limit potential

downside risks in rising markets. While there is no profit in this
scenario, the strategy also prevents excessive losses, making it a
useful component of a broader risk management framework.

Reconciliation with Banking Practices

For banks, managing foreign exchange risk is a critical aspect of their

operations, especially given the potential for significant currency fluctuations to
impact profitability. The Bear Spread strategy, as analyzed here, aligns with
several key principles of risk management in banking:

1. Hedging Against Adverse Movements:

 By employing options with different strike prices, banks can create

a cost-effective hedge that mitigates the impact of unfavorable
exchange rate movements. This is particularly relevant for banks
with substantial exposure to foreign currencies.

2. Balancing Cost and Protection:

 The net payoff results demonstrate the need for a balanced

approach to cost and protection. While the Bear Spread incurs an
initial cost, it offers valuable insurance against steep declines,
which can be reconciled with the bank's risk appetite and overall
hedging strategy.

3. Scenario Planning and Stress Testing:

 Conducting scenario analyses, as shown in this case study, helps

banks prepare for various market conditions and understand the
potential outcomes of their risk management strategies. This

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 practice is essential for effective stress testing and ensuring
resilience against market volatility.

V. List of References:
1. The right way to hedge | McKinsey.
https://www.mckinsey.com/capabilities/strategy-and-corporate-finance/
our-insights/the-right-way-to-hedge.
2. How Leading Banks Manage Corporate Client Profitability.
https://www.bain.com/insights/how-leading-banks-manage-corporate-
client-profitability-forbes/.
3. Chapter 5: Measuring Risk–Introduction - MIT.
http://web.mit.edu/15.423/test/notes/pdf/Text_Ch_5_Measuring_Risk_Intr
oduction.pdf.
4. Risk Management, Derivatives, and Financial Analysis under SFAS No.
133. https://www.cfainstitute.org/-/media/documents/book/rf-
publication/2001/rf-v2001-n1-3913-pdf.pdf.

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 5. Understanding Interest Rate Swaps with Examples | LAT Blog.
https://www.lat.london/news-resources/news-blog/understanding-interest-
rate-swaps-with-examples/.
6. Real-life Case Studies and Examples in Options Trading.
https://www.theoptionszone.com/blog/real-life-case-studies-options.
7. Futures and Forwards - Definition and Examples.
https://corporatefinanceinstitute.com/resources/derivatives/futures-
forwards/.
8. Black, F., & Scholes, M. (1973). The Pricing of Options and Corporate
Liabilities. Journal of Political Economy, 81(3), 637-654.
doi:10.1086/260062
9. Hull, J. C. (2017). Options, Futures, and Other Derivatives (10th ed.).
Pearson.
10.Bodie, Z., Kane, A., & Marcus, A. J. (2018). Investments (11th ed.).
McGraw-Hill Education.
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Risk Management (10th ed.). Cengage Learning.
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 17.Garman, M. B., & Kohlhagen, S. W. (1983). Foreign Currency Option
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doi:10.1016/S0261-5606(83)80001-1

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