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A risk control tool for foreign financial activities – A new derivatives pricing model

Author

Listed:
  • I-Ming Jiang

    (Yuan Ze University)

  • Chia Chun Lo

    (Prince Mohammad Bin Salman College (MBSC))

  • Andreas Karathanasopoulos

    (American University of Beirut)

  • Konstantinos Skindilias

    (University of Greenwich
    ABM-Analytics Ltd)

Abstract

Investors as well as firms are concerned with not only foreign/domestic stock price risk but also foreign exchange rate risk when making decisions for investing (or financing) overseas. In this paper, a new contingent claim is proposed for the derivatives markets for use in the domestic or foreign derivatives markets. Particularly, we address hedging against stock and exchange rate risk while adjusting for protecting the value of a collateralized stock. We introduce a closed-form solution for a Quanto put option coupled with a reset feature to hedge against downside risk while maintain upside potential from foreign investments. The Quanto options meet the investors’ concerns for exchange rate risk while the reset feature locks in value against downside stock risk. The proposed product is an efficient tool for risk management and aims to support decision making for firms when considering financing and investing in the foreign markets.

Suggested Citation

  • I-Ming Jiang & Chia Chun Lo & Andreas Karathanasopoulos & Konstantinos Skindilias, 2017. "A risk control tool for foreign financial activities – A new derivatives pricing model," Journal of Asset Management, Palgrave Macmillan, vol. 18(4), pages 269-294, July.
    • Handle: RePEc:pal:assmgt:v:18:y:2017:i:4:d:10.1057_s41260-016-0023-6
    DOI: 10.1057/s41260-016-0023-6
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    References listed on IDEAS

    as
    1. Loriano Mancini & Angelo Ranaldo & Jan Wrampelmeyer, 2013. "Liquidity in the Foreign Exchange Market: Measurement, Commonality, and Risk Premiums," Journal of Finance, American Finance Association, vol. 68(5), pages 1805-1841, October.
    2. Stephen F. Gray & Robert E. Whaley, 1999. "Reset Put Options: Valuation, Risk Characteristics, and an Application," Australian Journal of Management, Australian School of Business, vol. 24(1), pages 1-20, June.
    3. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    4. Philippas, Dionisis & Siriopoulos, Costas, 2013. "Putting the “C” into crisis: Contagion, correlations and copulas on EMU bond markets," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 27(C), pages 161-176.
    5. Allayannis, George & Ofek, Eli, 2001. "Exchange rate exposure, hedging, and the use of foreign currency derivatives," Journal of International Money and Finance, Elsevier, vol. 20(2), pages 273-296, April.
    6. Gounopoulos, Dimitrios & Molyneux, Philip & Staikouras, Sotiris K. & Wilson, John O.S. & Zhao, Gang, 2013. "Exchange rate risk and the equity performance of financial intermediaries," International Review of Financial Analysis, Elsevier, vol. 29(C), pages 271-282.
    7. Bartram, Söhnke M. & Brown, Gregory W. & Conrad, Jennifer, 2011. "The Effects of Derivatives on Firm Risk and Value," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 46(4), pages 967-999, August.
    8. Chang, Feng-Yi & Hsin, Chin-Wen & Shiah-Hou, Shin-Rong, 2013. "A re-examination of exposure to exchange rate risk: The impact of earnings management and currency derivative usage," Journal of Banking & Finance, Elsevier, vol. 37(8), pages 3243-3257.
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    More about this item

    Keywords

    Quanto options; reset options; exchange rate risk; market risk; decision making;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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