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Risk Management Case Study : Currency Option Overlay

Risk Management Case Study : Currency Option Overlay. presented to. CCAD2005 - Québec. Maxime Tessier Vice President Currency Management. 18 August 2005. Parameters of the problem Three phases of the overlay Performance conclusions. Parameters of the problem.

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Risk Management Case Study : Currency Option Overlay

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  1. Risk Management Case Study:Currency Option Overlay presented to CCAD2005 - Québec • Maxime TessierVice President Currency Management 18 August 2005

  2. Parameters of the problem • Three phases of the overlay • Performance conclusions

  3. Parameters of the problem Underlying Manager Profile and Objective • Underlying currency manager chooses long/short forward-based strategies. • Investment horizon is three months, linear and 55% right (ex-ante). • Stop-loss is set at one-third of the expected gain fixed from starting point. • Stop-loss is continuous. • Objectives: improve the return/risk ratio of this strategy with option overlay.

  4. Parameters of the problem Case Study: Bullish Strategy on EUR/NOK

  5. Parameters of the problem “Normal View” versus Manager’s “Actual View” B 45% A A+B=55%

  6. Parameters of the problem Calculating the Actual Expected Payoff: 0,076% In first month, risk of 1% stop is 45%. In second month, it is 14%. In third month, it is 2% Manager is right (55%) Gross expected return 3% P x 3% = [(1-45%)*(1-14%)*(1-2%)] x 3% (1-P) x –1% = 53.6% x –1% .766% -.295% Over three months, the risk of 1% being touched is 87.8%. Manager is wrong (45%) Gross expected return 0% 12.2% x 0% 87.8% x –1% 0.000% -.395% Without a 1% stop, the actual expected payoff would be just over 1%

  7. Three Phases of Overlay Viewing the Manager’s view and historical returns Note: it is assumed that the ex-ante upside distribution for the manager’s view does not exceed the historical distribution (I.e. view distribution is skewed)

  8. Three Phases of Overlay EUR/NOK Historical Return Profile

  9. Three Phases of Overlay EUR/NOK Historical Volatility Profile Note: data based on annualized data using percent returns from end-month to end-month (WMRH data).

  10. Three Phases of Overlay Option Price Graph Note: composite implied volatility quotes (Bloomberg data).

  11. Parameters of the problem • Three phases of the overlay • Performance conclusions

  12. Risk Management Case Study:Currency Option Overlay presented to CCAD2005 - Québec • Maxime TessierVice President Currency Management 18 August 2005

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