Delta Hedging at Dayton Manufacturing

Contents
Delta hedge updates:.............................................................................2
Table 1: Inputs......................................................................................................... 2
Delta Calculation:.................................................................................................... 2
Table 2: Daytons Delta Hedging Analysis US Dollar /Euro Spring 2005................3
Table 3: Delta hedge results.................................................................................... 3
Table 4: Hedging Alternatives Comparison with Simple full forward covered..........3
Performance of Delta hedging in the current context:..............................4
Table 5: Dollar movement Scenarios and strategy performance comparison:.........4
Case1: Stable Dollar-............................................................................................... 4
Case2: Dollar Strong-.............................................................................................. 4
Riskiness of Delta Hedging for Dayton Manufacturing:.............................5
Table 6: Rank wise comparison of the 4 strategies:.................................................5
Justification for delta hedging to be better than other strategies:...........................5
Delta hedging similarity to forward contract:.......................................................5
Continuous update of delta for best performance:...............................................6
Minimal cost of Hedging:...................................................................................... 6
Flexibility:............................................................................................................. 6
Conclusion:........................................................................................................... 6
Subjectivity of Delta hedging in its approach to both the direction of an
exchange rate movement and the proportion of hedge cover:..................7
Figure 1: Delta values w.r.t. change in underlying values........................................7
Recommendations of Delta hedging for Dayton manufacturing:................8
Exchange rate against Dayton manufacturing (Dollar getting stronger):................8
Exchange rates moving randomly in a bounded region around a pegged value:....8
Exchange rate movements favorable to Dayton Manufacturing (Dollar getting
weaker):.................................................................................................................. 8
References:...........................................................................................9

Delta Hedging at Dayton Manufacturing

Delta hedge updates:

Following are the inputs for the initial delta, as given in the case.

Table 1: Inputs
Spot rate
Strike price (same units as
Spot)
volatility (annualized)
domestic
interest
rate
(annualized)
foreign
interest
rate
(annualized)
time to maturity in days
Put option value

Inputs
$1.3309/E
uro
$1.335/Eur
o
10.00%
3.30%
2.00%
92
$0.0265/E
uro

Delta Calculation:
Here delta is calculated using the formula

S0: Spot rate.

X: Strike rate.
r: domestic rate.
q: foreign exchange rate.
Sigma: annualized volatility.
t: time to maturity.
Delta calculation is done as illustrated by Jorion, (2009) in the book Financial Risk
Manager Handbook.
The following gives the formula for put delta:

Delta Hedging at Dayton Manufacturing

The initial vale of delta using this formula is (-0.4859). The negative sign indicates a
put delta.
Using the above value of delta as initial value, proportionate hedging is done by
buying forward contracts, while some part of the portfolio is kept uncovered. When
86 days to maturity are left, the delta is recalculated for the new spot price and
time to maturity. The portfolio is re aligned with new values of delta. The process is
repeated every week till maturity. Table 2 below lists down the deltas and forward
contracts bought and sold at updated values of delta.

Table 2: Daytons Delta Hedging Analysis US Dollar /Euro

Spring 2005
Updat
e
numbe
r
1

Number
of Days
to
maturity
92

Spot
Rate

Delta

Optimal
hedge

Hedge
adjustmen
ts

Remaining
uncovered

Sold or
bought
Forward

Forward
rate

Forward
proceed
s.

1.3309

-485900

514100

-485900

1.3353

86

1.2956

-698600

-212700

301400

-212700

1.2996

78

1.2893

-745500

-46900

254500

-46900

1.2929

71

1.2908

-750100

-4600

249900

-4600

1.2941

648822.
27
276424.
92
60637.0
1
5952.86

64

1.2926

0.4859
0.6986
0.7455
0.7501
-0.754

-754000

-3900

246000

-3900

1.2956

5052.84

57

1.3068

-678400

75600

321600

75600

1.3095

50

1.2919

-791700

-113300

208300

-113300

1.2942

43

1.2834

-859400

-67700

140600

-67700

1.2854

36

1.2643

-951300

-91900

48700

-91900

1.2659

10

29

1.2555

-981700

-30400

18300

-30400

1.2568

11

22

1.2568

-990900

-9200

9100

-9200

1.2578

12

15

1.2227

-999200

-8300

800

-8300

1.2234

13

1.2128

-999600

-400

400

-400

1.2132

98998.2
146632.
86
87021.5
8
116336.
21
38206.7
2
11571.7
6
10154.2
2
485.28

14

1.2239

0.6784
0.7917
0.8594
0.9513
0.9817
0.9909
0.9992
0.9996
0.9999

-999900

-300

100

-300

1.2239

367.17

15

1.2200

Table 3 calculates the final value of the portfolio at the end of the period. The
uncovered proceeds are added to the forward proceeds, bought at different
updates:

Delta Hedging at Dayton Manufacturing

Table 3: Delta hedge results

Delta hedge results
Net
Proceeds
from
forwards
Proceeds from uncovered
Total dollar Proceeds

1308668
122
1308790

The four hedging strategies are compared in table 4. Here forward contract is used
as benchmark and value of the portfolio at the end of the period using each of the
strategies are compared.

Table 4: Hedging Alternatives Comparison with Simple full

forward covered.
Hedging Alternatives Comparison with Simple full forward covered
Remained uncovered
1220000
-115300
Forward covered
1335300
0
Put Option Cover
1308500
-26800
Delta Hedge
1308789.5
-26510.5

Performance of Delta hedging in the current context:

Table 5: Dollar movement Scenarios and strategy performance
comparison:
Strike Rate
Volatility
Domestic interest
rates
Foreign
Interest
rates
Forward
Rate
Range
Spot Rate Range
Remained
uncovered
Forward covered
Put Option Cover

Dollar Stable
1.75
no
5.06%
6%

Dollar Strong
1.75
yes
5.06%
6%

Dollar Strong
1.9
no
10%
3.30%

Dollar Strong
1.335
no
10%
3.30%

8%

8%

4%

2%

1.754

1.7612

1.754

1.7371

1.905

1.8286

1.3353

1.2239

1.764
176180
0

1.7618
2792.00

1.764
17350
00

1.735
-10522

1.9111
183110
0

1.8311
-41577

1.3309
122000
0

175400
0
173462
5

5008.00
24383.0
0

17540
00
17346
35

8478.0
0
-10887

190496
0
186381
8

32283.
00
-8859

133530
0
130850
0

1.22
88789.
5
26510.
50
289.50

Delta Hedging at Dayton Manufacturing

Delta Hedge

175900
8

0.00

17455
22

0.00

187267
7

0.00

130879
0

0.00

Note: here Delta hedge is kept as reference and other strategies are compared with
that.

The above table compares the performance of Delta hedge with respect to 4
different strategies. The green indicates money is made and red indicates the
money is lost with respect to the Delta hedge strategy. The comparison is done in
the 4 scenarios given in the case.

Case1: Stable DollarIn case of Stable dollar, the forward contract loses money. For the Put option, as
discussed by John H, (2013), the cost of purchasing a put option is very high and
hence the strategy looses the highest in this case. Here delta hedging is the closest
to the opening spot rate conversion of the accounts receivable for Dayton, which is
by definition the motive behind hedging as discussed by Longo J (2009). This value
of portfolio minimizes the uncertainty in portfolio performance with change in
underlying value change. For stable dollar, uncovered strategy pays the most, as
the exchange rate moves around a pegged value.

Case2: Dollar StrongIn scenario 2 as given in the case study the dollar is going to be stronger and thus
taking a forward position on the entire portfolio is the best strategy. Put Option
Cover and uncovered both losses a big sum of money, with respect to Delta hedge
and forward rate contract. The same thing repeats in the scenario 3 and scenario 4
as well.

Riskiness of Delta Hedging for Dayton Manufacturing:

In the current context, if we compare the 4 scenarios as given in the case study and
rank the strategies:
Delta hedge ranks 2nd best in all 4 cases. This makes the delta hedging strategy as
the best of 4 strategies.

Delta Hedging at Dayton Manufacturing

Table 6: Rank wise comparison of the 4 strategies:

Remained
uncovered
Forward covered
Put Option Cover
Delta Hedge

Scenario
1
Dollar
Stable
1

Scenario
2
Dollar
Strong
4

Scenario
3
Dollar
Strong
4

Scenario
4
Dollar
Strong
4

3
4
2

1
3
2

1
3
2

1
3
2

Justification for delta hedging to be better than other

strategies:
In the case study given, in 3 out of 4 scenarios, dollar was going to be stronger.
While in only one case the dollar was predicted to be stable.

Delta hedging similarity to forward contract:

Delta hedging uses linear hedging (forward covered options) for hedging the
position as discussed at optiontradingtips. Delta value tells the amount of the
portfolio that should be covered to the total portfolio to make the risk of the
portfolio to zero as discussed by Giovanni B (June 1987). Delta here is borrowed
from the Black and Scholes model basics. So in a way, delta hedging is forward
covered hedging, but a part of portfolio is forward covered, and the part is decided
by delta.

Continuous update of delta for best performance:

Delta is kept to be updated, as the value of the underlying, (here the spot rates)
changes the delta value changes, and the portfolio is no longer a risk free portfolio
for new value of the delta. Hence the delta value needs to be updated and the value
of the portfolio under the forward cover needs to be changed. When the number of
the updates is increased the performance of the portfolio improves further, and in
fully dynamically updated delta hedging, the portfolio delta is changed every day to
achieve best results. The same thing is discussed by Rajiv S. (2014) in the book
Derivative and Risk management.

Delta Hedging at Dayton Manufacturing

When the movement of the underlying of the portfolio is known, then it is better to
not to go for delta hedging, but simply go for a forward contract. The forward
contract will fetch the best results, if the dollar is predicted to go stronger and
uncovered contract if the dollar to go weak. But such kinds of cases are hardly
available.

Minimal cost of Hedging:

Secondly, every hedging scheme comes with a cost, while delta hedging suggests a
value of optimum value of hedging required to make the portfolio risk free. This
makes delta hedging a better strategy than standard forward contract hedging for
100% portfolio or buying put option cover. The cost of hedging is minimized by the

Flexibility:
Delta hedging increases the flexibility for the hedgers. The losses made by delta
hedging can be considered as reasonable price for the level of flexibility offered by
delta hedging.

Conclusion:
For any arbitrary context, when the movement of the underlying is not predictable,
Delta hedging, with the most number of updates is the most suitable strategy. Delta
hedging takes a position making the portfolio risk free for that particular value of
spot price, which is tuned by updating the value of delta every time, making the
overall performance of the delta hedge better. Also the hedging cost is minimized
by using delta hedging strategy.

Subjectivity of Delta hedging in its approach to both the

direction of an exchange rate movement and the
proportion of hedge cover:
Delta hedging is a selective forward rate hedging technique, with a part of the
portfolio only covered with forward contract, while remaining part uncovered.

Delta Hedging at Dayton Manufacturing

To compare the subjectivity for the delta on either side changes in the underlying
(Here spot price of the stock is the underlying.), Let us consider the following graph,
which shows the put delta values for the underlying price.

Figure 1: Delta values w.r.t. change in underlying values

The curve is a symmetric curve on both the sides with the value of delta changing
the most in the middle and saturating at the ends. This clearly shows that the delta
is not specific to the movements on either side of the exchange rates. The curve is
taken from Dynamic Hedging. (2015) from riskencyclopedia.com
Now as delta hedging used these values of deltas, delta hedging is also symmetric
for either side of exchange rate changes.
Sometimes, by observing the movement of the delta with respect to the change in
the spot rate, it may seem that delta is changing more on one direction with the
change in value of spot rate. The reason for this is the delta is a function of time
and volatility, in addition to the spot rate. So as the time to maturity reduces, delta
tends to move towards 0 in stable dollar case and -1 in stronger dollar case. This
movements in delta with respect to time curtails the opposite side movement of
delta due to exchange rate moving in opposite direction then the normal trend.
Thus it is clear that Delta is not subjective on the movement directions of the
underlying spot rates. With symmetric delta, the hedge cover also becomes
symmetric with respect to the movement in interest rates.

Recommendations of Delta hedging for Dayton

manufacturing:

Delta Hedging at Dayton Manufacturing

A scenario based hedging strategy, would be recommended to the CFO, where in for
some predicted spot rate changes, forwards rate hedging would be suggested, while
in case of times when exchange rate is moving randomly, a delta hedging strategy
will be suggested.

Exchange rate against Dayton manufacturing (Dollar getting

stronger):
As we saw in scenario 2, 3 and 4 in table 5, whenever the exchange rate is moving
against the company, forward rate hedging becomes the best strategy. Forward rate
hedging clips the losses happening due to domestic currency going stronger. So,
whenever the domestic and foreign interest rates and other macroeconomic
parameters are indicating strengthening of the dollar, than a plain forward rate
hedging would be suggested as given by Banks (2006) in his book for a exporting
form like Dayton.

Exchange rates moving randomly in a bounded region around a

pegged value:
But, when the exchange rate movements are totally unpredictable and may go up
and down from its center value, as in case of the scenario 1, where exchange rates
were stable, Delta hedging would be recommended. Moreover, more number of
updates would be recommended for the delta hedging. The frequency of the
updates will be decided by the volatility of the underlying spot rate.
As being delta hedged, the spot rates movements are not affecting the portfolio
because the delta hedging is making it risk free every time whenever delta update
is made. But as discussed by Antonio C. (2009) higher the value of volatility of spot
rate, faster and larger is the movement of the spot rate. With every movement of
spot rate the delta equilibrium is disturbed and an update is required. Greeks like
Vega can be used to monitor the movements of the volatility.

Exchange rate movements favorable to Dayton Manufacturing

(Dollar getting weaker):
When it is expected that dollar is going to be weaker. As discussed by Alok D (2012)
this condition is favorable for the company with receivables in the foreign currency;
the dollar returns are going to be higher. In that case an uncovered portfolio will be
the best option.

Delta Hedging at Dayton Manufacturing

Thus, a balanced mix of 3 strategies should be used for different kind of movements
if exchange rate.

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