I'm using the 2005 assignment. Qn6.5 which asks how a student who has invested the entire portfolio in domestic equities can obtain exposure in international equities using options. Ok, I understand that he can buy call options on overseas equity indices but I do not understand why he should simultaneously sell call options in the domestic equity market to hedge domestic exposure. They call this delta hedging. How does it work? Can someone help please?
I'm no expert but I think the two ideas (without looking at the details of the question) are: 1) you need cash to buy call options in foreign markets. Selling your own call options gives you this. 2) You want foreign exposure because you are too exposed to the local market. Therefore you may want to decrease your local exposure. Another idea which is a combination of the two above, is that you probably want/need to keep the overall exposure the same, because you don't have more capital and buying options (while "cheap") without correspondingly selling options on stocks you own would significantly increase your level of gearing. If your original aim was to manage/mitigate risk, increasing your gearing is unlikely to have the desired outcome.
