31 May Noon study -Currency Management Practice Question

https://study.cfainstitute.org/app/cfa-institute-program-level-iii-for-august-2024#quiz/take/study_task/2563123

https://study.cfainstitute.org/app/cfa-institute-program-level-iii-for-august-2024#quiz/take/study_task/2563133

https://study.cfainstitute.org/app/cfa-institute-program-level-iii-for-august-2024#quiz/take/study_task/2563143

https://study.cfainstitute.org/app/cfa-institute-program-level-iii-for-august-2024#quiz/take/study_task/2563153

Q.

Kalila Al-Khalili has been hired as a consultant to a Middle Eastern sovereign wealth fund. The fund’s oversight committee has asked her to examine the fund’s financial characteristics and recommend an appropriate currency management strategy given the fund’s Investment Policy Statement. After a thorough study of the fund and its finances, Al-Khalili reaches the following conclusions:

• The fund’s mandate is focused on the long-term development of the country, and the royal family (who are very influential on the fund’s oversight committee) are prepared to take a long-term perspective on the fund’s investments.

• The fund’s strategic asset allocation is tilted towards equity rather than fixed-income assets.

• Both its fixed-income and equity portfolios have a sizeable exposure to emerging market assets.

• Currently, about 90% of exchange rate exposures are hedged although the IPS allows a range of hedge ratios.

• Liquidity needs of the fund are minimal, since the government is running a balanced budget and is unlikely to need to dip into the fund in the near term to cover fiscal deficits. Indeed, the expected lifetime of country’s large oil reserves has been greatly extended by recent discoveries, and substantial oil royalties are expected to persist into the future.

Based on her investigation, Al-Khalili would most likely recommend:

1. A.active currency management.

2. B.a hedging ratio closer to 100%.

3. C.a narrow discretionary band for currency exposures.

Solution

A is correct. The fund has a long-term perspective, few immediate liquidity needs, and a lower weight in fixed income that in equities (bond portfolios are typically associated with hedge ratios closer to 100% than equity portfolios). The emerging market exposure would also support active management, given these countries’ typically higher yields (carry trade) and often volatile exchange rates.

B is incorrect because the characteristics of the fund and the beneficial investor (in this case, the royal family) do not argue for a conservative currency strategy.

C is incorrect because a more active currency management strategy would be more suitable for this fund.

Kamala Gupta, a currency management consultant, is hired to evaluate the performance of two portfolios. Portfolio A and Portfolio B are managed in the United States and performance is measured in terms of the US dollar (USD). Portfolio A consists of British pound (GBP) denominated bonds and Portfolio B holds euro (EUR) denominated bonds.

Gupta calculates a 19.5% domestic-currency return for Portfolio A and 0% domestic-currency return for Portfolio B.

Q.

Analyze the movement of the USD against the foreign currency for Portfolio A. Justify your choice.

Template for Question 1

Asset	Foreign-Currency Portfolio Return	USD Relative to Foreign-Currency (circle one)
Portfolio A	15%	appreciated / depreciated

Portfolio A consists of GBP bonds, so if 15% foreign currency return, it means GBP appreciated and hence USD relatively depreciated.

I got wrong

15% foreign currency return means return of the bond measured in foreign currency, it then add returns in foreign currency relative to domestic currency to convert it into domestic-currency return

as DCR is 19.5%, higher than 15% of the asset returns, it means the foreign currency appreciated as well. (USD depreciated)

Justification

The 19.5% domestic-currency return for Portfolio A is higher than the 15% foreign-currency portfolio return in GBP; therefore, the USD necessarily depreciated relative to the GBP.

The domestic-currency return on a foreign portfolio will reflect both the foreign-currency return on the portfolio and the percentage movements in the spot exchange rate between the domestic and foreign currency. The domestic-currency return is multiplicative with respect to these two factors:RDC = (1 + RFC)(1 + RFX) – 1

where RDC is the domestic-currency return (in percent), RFC is the foreign-currency return of the asset (portfolio), and RFX is the percentage change of the foreign currency against the domestic currency. (Note that in the RFX expression the domestic currency—the USD in this case—is the price currency.)Solving for RFX: (1 + 15%)(1 + RFX) – 1 = 19.50%; RFX = 3.91%

Thus, the USD depreciated relative to the GBP. That is, the GBP appreciated against the USD because RFX is quoted in terms of USD/GBP, with the USD as the price currency and GBP as the base currency, and in this example RFX is a positive number (3.91%).

Kamala Gupta, a currency management consultant, is hired to evaluate the performance of two portfolios. Portfolio A and Portfolio B are managed in the United States and performance is measured in terms of the US dollar (USD). Portfolio A consists of British pound (GBP) denominated bonds and Portfolio B holds euro (EUR) denominated bonds.

Gupta calculates a 19.5% domestic-currency return for Portfolio A and 0% domestic-currency return for Portfolio B.

Question

Q.

Analyze the foreign-currency return for Portfolio B. Justify your choice.

Template for Question 2

Asset	Percentage Movement in the Spot Exchange Rate	Foreign-Currency Portfolio Return (circle one)
Portfolio B	EUR appreciated 5% against the USD	positive/negative

the portfolio contains EUR demoniated bonds, so if EUR appreciated but 0% domestic return, meaning the portfolio foreign currency return is negative to offset the appreciation in EUR

Justification

The domestic-currency return for Portfolio B is 0%, and the EUR appreciated 5% against the USD; therefore, the foreign-currency return for Portfolio B is necessarily negative.

The domestic-currency return on a foreign portfolio will reflect both the foreign-currency return on the portfolio and the percentage movements in the spot exchange rate between the domestic and foreign currency. The domestic-currency return is multiplicative with respect to these two factors:RDC = (1 + RFC)(1 + RFX) – 1

where RDC is the domestic-currency return (in percent), RFC is the foreign-currency return of the asset (portfolio), and RFX is the percentage change of the foreign currency against the domestic currency. (Note that once again, the domestic currency—the USD—is the price currency in the USD/EUR quote for RFX.)Solving for RFC: (1 + RFC)(1 + 5%) – 1 = 0%; RFC = –4.76%

Q.

The fund manager of Portfolio B is evaluating an internally-managed 100% foreign-currency hedged strategy.

Discuss two forms of trading costs associated with this currency management strategy.

first is the costs of hedging derivatives

second is cost of expertise to manage the hedge

Solution

Any two of the following four points is acceptable:

• Trading requires dealing on the bid/offer spread offered by dealers. Dealer profit margin is based on these spreads. Maintaining a 100% hedge will require frequent rebalancing of minor changes in currency movements and could prove to be expensive. “Churning” the hedge portfolio would progressively add to hedging costs and reduce the hedge’s benefits.

• [Options] A long position in currency options involves an upfront payment. If the options expire out-of-the-money, this is an unrecoverable cost.

• [Forward] Forward contracts have a maturity date and need to be “rolled” forward with an FX swap transaction to maintain the hedge. Rolling hedges typically generate cash inflows and outflows, based on movements in the spot rate as well as roll yield. Cash may have to be raised to settle the hedging transactions (increases the volatility in the organization’s cash accounts). The management of these cash flow costs can accumulate and become a large portion of the portfolio’s value, and they become more expensive for cash outflows as interest rates increase.

• Hedging requires maintaining the necessary administrative infrastructure for trading (personnel and technology systems). These overhead costs can become a significant portion of the overall costs of currency trading.

Q.

Gupta tells the fund manager of Portfolio B:

“We need to seriously consider the potential costs associated with favorable currency rate movements, given that a 100% hedge-ratio strategy is being applied to this portfolio.”

Explain Gupta’s statement in light of the strategic choices in currency management available to the portfolio manager.

For favorable currency movements, there'll be hedging cost [Trading cost] and the cost of losing these favorable currency [-> Opportunity cost].

it's wrong understanding - the person saying 'potential costs associated with favorable currency rate movements' means opportunity cost

Solution

Optimal hedging decisions require balancing the benefits of hedging against the costs of hedging. Hedging costs come mainly in two forms: trading costs and opportunity costs. Gupta is referring to the opportunity cost of the 100% hedge strategy. The opportunity cost of the 100% hedge strategy for Portfolio B is the forgone opportunity of benefiting from favorable currency rate movements. Gupta is implying that accepting some currency risk has the potential to enhance portfolio return. A complete hedge eliminates this possibility.

https://chatgpt.com/c/a741ae21-7233-4978-a43a-3afcacf2b005

Q.

The investment policy statement (IPS) for Portfolio A provides the manager with discretionary authority to take directional views on future currency movements. The fund manager believes the foreign currency assets of the portfolio could be fully hedged internally. However, the manager also believes existing firm personnel lack the expertise to actively manage foreign-currency movements to generate currency alpha.

Recommend a solution that will provide the fund manager the opportunity to earn currency alpha through active foreign exchange management.

Your Answer:

can sell currency options to get premium

---

Solution

A solution is to put in place a currency overlay program for active currency management. Because internal resources for active management are lacking, the fund manager would outsource currency exposure management to a sub-advisor that specializes in foreign exchange management. This approach would allow the fund manager of Portfolio A to separate the currency hedging function (currency beta), which can be done effectively internally, and the active currency management function (currency alpha) which can be managed externally by a foreign currency specialist.

Q.

Gupta and the fund manager of Portfolio A discuss the differences among several active currency management methods.

Evaluate each statement independently and select the active currency approach it best describes. Justify each choice.

https://chatgpt.com/c/6c00e0f5-199f-42d4-93e3-4e9f4a95ae16

Template for Question 6

Wilson Manufacturing (Wilson) is an Australian institutional client of Ethan Lee, who manages a variety of portfolios across asset classes. Wilson prefers a neutral benchmark over a rules-based approach, with its investment policy statement (IPS) requiring a currency hedge ratio between 97% and 103% to protect against currency risk. Lee has assessed various currency management strategies for Wilson’s US dollar-denominated fixed-income portfolio to optimally locate it along the currency risk spectrum. The portfolio is currently in its flat natural neutral position because of Lee’s lack of market conviction.

Q.Identify the most likely approach for Lee to optimally locate Wilson’s portfolio on the currency risk spectrum, consistent with the IPS. Justify your response with two reasons supporting the approach.

Identify the most likely approach for Lee to optimally locate Wilson’s portfolio on the currency risk spectrum, consistent with IPS. (Circle one.)
Passive Hedging	Discretionary Hedging	Active Currency Management	Currency Overlay
Justify your response with two reasons supporting the approach.

Passive hedging?

Solution

• Discretionary Hedging

1. The portfolio is said to be in its flat natural neutral position because Lee does not have market conviction, which is consistent with a discretionary hedging approach.

2. The currency hedge ratio requirement reflects some discretion with actual portfolio currency risk exposures allowed to vary from the neutral position within a 3% band.

Passive hedging is not likely because the IPS allows the 3% band around the neutral position. In addition, passive hedging is a rules-based approach, which is contrary to Wilson’s preference.

Active currency management is not likely because the 3% band around the neutral position is too limited for that approach. In many cases, the difference between discretionary hedging and active currency management is more of emphasis than degree. The primary duty of the discretionary hedger is to protect the portfolio from currency risk. Active currency management is supposed to take currency risks and manage them for profit. Leaving actual portfolio exposures near zero for extended periods is typically not a viable option.

Currency overlay is not likely because the 3% band is too small to indicate active currency management in a currency overlay program. In addition, currency overlay programs are often conducted by external, FX-specialized sub-advisers to a portfolio, whereas Lee is a generalist managing a variety of portfolios across asset classes. Finally, currency overlay allows for taking directional views on future currency movements, and a lack of market conviction is noted here.

Q.

Lee and Wilson recently completed the annual portfolio review and determined the IPS is too short-term focused and excessively risk averse. Accordingly, the IPS is revised and foreign currency is introduced as a separate asset class. Lee hires an external foreign exchange sub-adviser to implement a currency overlay program, emphasizing that it is important to structure the program so that the currency overlay is allowed in terms of strategic portfolio positioning.

Discuss a key attribute of the currency overlay that would increase the likelihood it would be allowed in terms of strategic portfolio positioning.

Your Answer:not sure

---

Solution

The IPS revision allows for a more proactive currency risk approach in the portfolio because it was determined Wilson was too short-term focused and risk averse.

Lee should structure the currency overlay so that it is as uncorrelated as possible with other asset or alpha-generation programs in the portfolio. By introducing foreign currencies as a separate asset class, the more currency overlay is expected to generate alpha that is uncorrelated with the other programs in the portfolio, the more likely it is to be allowed in terms of strategic portfolio positioning.

Mason Darden is an adviser at Colgate & McIntire (C&M), managing large-cap global equity separate accounts. C&M’s investment process restricts portfolio positions to companies based in the United States, Japan, and the eurozone. All C&M clients are US-domiciled, with client reporting in US dollars.

Darden manages Ravi Bhatt’s account, which had a total (US dollar) return of 7.0% last year. Darden must assess the contribution of foreign currency to the account’s total return. Exhibit 1 summarizes the account’s geographic portfolio weights, asset returns, and currency returns for last year.

Exhibit 1:

Performance Data for Bhatt’s Portfolio Last Year

Geography	Portfolio Weight	Asset Return	Currency Return
United States	50%	10.0%	NA
Eurozone	25%	5.0%	2.0%
Japan	25%	–3.0%	4.0%
Total	100%

Question

Q.

Calculate the contribution of foreign currency to the Bhatt account’s total return. Show your calculations.

Q.

Darden meets with Bhatt and learns that Bhatt will be moving back to his home country of India next month to resume working as a commodity trader. Bhatt is concerned about a possible US recession. His investment policy statement (IPS) allows for flexibility in managing currency risk. Overall returns can be enhanced by capturing opportunities between the US dollar and the Indian rupee (INR) within a range of plus or minus 25% from the neutral position using forward contracts on the currency pair. C&M has a currency overlay team that can appropriately manage currency risk for Bhatt’s portfolio.

Determine the most appropriate currency management strategy for Bhatt. Justify your response.

Determine the most appropriate currency management strategy for Bhatt. (Circle one.)
Passive hedging	Discretionary hedging	Active currency management
Justify your response.

Active currency management.

as +- 25% from neutral positio is adequate range to allow some adjustment to capture for possible US recession.

Solution

Active currency management is the most appropriate currency management strategy because with this approach, the portfolio manager is supposed to take currency risks and manage them for profit with the primary goal of adding alpha to the portfolio through successful trading. This primary goal differs from the discretionary hedging approach in which the manager’s primary duty is to protect the portfolio from currency risk and secondarily seek alpha within limited bounds. While the difference between active currency management and discretionary hedging is one of emphasis more than degree, the bounded discretion that Bhatt has granted Darden (plus or minus 25% from the neutral position) strongly suggests that Darden is expected to take currency risk and seek alpha with priority over portfolio protection from currency risk.

Passive hedging is not appropriate because with this approach, the goal is to keep the portfolio’s currency exposures close, if not equal to, those of a benchmark portfolio used to evaluate performance. Passive hedging is a rules-based approach that removes all discretion from the portfolio manager, regardless of the manager’s market opinion on future movements in exchange rates. In this case, Bhatt has granted Darden the discretion to manage currency exposures within a range of plus or minus 25% from the neutral benchmark position.

A discretionary hedging approach is not appropriate because Bhatt has granted Darden more than limited discretion (plus or minus 25% from the neutral position), indicative of an active currency management approach. The discretion granted suggests that Darden’s primary goal is to take currency risks and manage them for profit with a secondary goal of protecting the portfolio from currency risk. The primary goal of a discretionary hedging approach is to protect the portfolio from currency risk while secondarily seeking alpha within limited bounds.

Q.

Following analysis of Indian economic fundamentals, C&M’s currency team expects continued stability in interest rate and inflation rate differentials between the United States and India. C&M’s currency team strongly believes the US dollar will appreciate relative to the Indian rupee.

C&M would like to exploit the perceived alpha opportunity using forward contracts on the USD10,000,000 Bhatt portfolio.

Recommend the trading strategy C&M should implement. Justify your response.

USD appreciate against IDR

C&M could buy IDR/UDR forward contracts, if USD appreciates relative to IDR.

Solution

Given C&M’s research conclusion and the IPS constraints, the currency team should under-hedge Bhatt’s portfolio by selling the US dollar forward against the Indian rupee in a forward contract (or contracts) at no less than a 75% hedge ratio of the portfolio’s USD10,000,000 market value. By under-hedging the portfolio relative to the “neutral” (100% hedge ratio) benchmark, the team seeks to add incremental value on the basis of its view that the US dollar will appreciate against the Indian rupee while maintaining compliance with the IPS.

Since the Indian rupee is assumed to depreciate against the US dollar, a 100% hedge ratio would largely eliminate any alpha opportunity. However, a hedge ratio greater than 75% but less than 100% (as dictated by the plus or minus 25% versus neutral IPS constraint) provides the opportunity to capture currency return in the expected US dollar appreciation against the Indian rupee.3

Guten Investments GmbH, based in Germany and using the EUR as its reporting currency, is an asset management firm providing investment services for local high net worth and institutional investors seeking international exposures. The firm invests in the Swiss, UK, and US markets, after conducting fundamental research in order to select individual investments. Exhibit 1 presents recent information for exchange rates in these foreign markets.

Exhibit 1:

Exchange Rate Data

	One Year Ago	Today
Euro-dollar (USD/EUR)*	1.1330	1.1550
Euro-sterling (GBP/EUR)	0.8445	0.8550
Euro-Swiss (CHF/EUR)	1.0875	1.0780

Q.

Based on Exhibit 1, the domestic-currency return over the last year (measured in EUR terms) was higher than the foreign-currency return for:

1. A.USD-denominated assets.
2. B.GBP-denominated assets.
3. C.CHF-denominated assets.

Solution

C is correct. The domestic-currency return is a function of the foreign-currency return and the percentage change of the foreign currency against the domestic currency. Mathematically, the domestic-currency return is expressed as:RDC = (1 + RFC)(1 + RFX) – 1

where RDC is the domestic-currency return (in percent), RFC is the foreign-currency return, and RFX is the percentage change of the foreign currency against the domestic currency. Note that this RFX expression is calculated using the investor’s domestic currency (the EUR in this case) as the price currency in the P/B quote. This is different than the market-standard currency quotes in Exhibit 1, where the EUR is the base currency in each of these quotes. Therefore, for the foreign currency (USD, GBP, or CHF) to appreciate against the EUR, the market-standard quote (USD/EUR, GBP/EUR, or CHF/EUR, respectively) must decrease; i.e. the EUR must depreciate.

The Euro-Swiss (CHF/EUR) is the only spot rate with a negative change (from 1.0875 to 1.0780), meaning the EUR depreciated against the CHF (the CHF/EUR rate decreased). Or put differently, the CHF appreciated against the EUR, adding to the EUR-denominated return for the German investor holding CHF-denominated assets. This would result in a higher domestic-currency return (RDC), for the German investor, relative to the foreign-currency return (RFC) for the CHF-denominated assets. Both the Euro-dollar (USD/EUR) and Euro-sterling (GBP/EUR) experienced a positive change in the spot rate, meaning the EUR appreciated against these two currencies (the USD/EUR rate and the GBP/EUR rate both increased). This would result in a lower domestic-currency return (RDC) for the German investor relative to the foreign-currency return (RFC) for the USD- and GBP-denominated assets.

A is incorrect because the Euro-dollar (USD/EUR) experienced a positive change in the spot rate, meaning the EUR appreciated against the USD (the USD/EUR rate increased). This would result in a lower domestic-currency (i.e. EUR-denominated) return relative to the foreign-currency return for the USD-denominated assets, since the USD has depreciated against the EUR.

B is incorrect because the Euro-sterling (GBP/EUR) experienced a positive change in the spot rate, meaning the EUR appreciated against the GPB (the GBP/EUR rate increased). This would result in a lower domestic-currency (i.e. EUR-denominated) return relative to the foreign-currency return for the GBP-denominated assets, since the GBP has depreciated against the EUR.

In prior years, the correlation between movements in the foreign-currency asset returns for the USD-denominated assets and movements in the exchange rate was estimated to be +0.50. After analyzing global financial markets, Konstanze Ostermann, a portfolio manager at Guten Investments, now expects that this correlation will increase to +0.80, although her forecast for foreign-currency asset returns is unchanged.

Ostermann believes that currency markets are efficient and hence that long-run gains cannot be achieved from active currency management, especially after netting out management and transaction costs. She uses this philosophy to guide hedging decisions for her discretionary accounts, unless instructed otherwise by the client.

Q.

Based on Ostermann’s correlation forecast, the expected domestic-currency return (measured in EUR terms) on USD-denominated assets will most likely:

1. A.increase.
2. B.decrease.
3. C.remain unchanged.

Solution

C is correct. An increase in the expected correlation between movements in the foreign-currency asset returns and movements in the spot exchange rates from 0.50 to 0.80 would increase the domestic-currency return risk but would not change the level of expected domestic-currency return. The domestic-currency return risk is a function of the foreign-currency return risk [σ(RFC)] the exchange rate risk [σ(RFX)] and the correlation between the foreign-currency returns and exchange rate movements. Mathematically, this is expressed as:σ2(RDC) ≈ σ2(RFC) + σ2(RFX) + 2σ(RFC)σ(RFX)ρ(RFCRFX)

If the correlation increases from +0.50 to +0.80, then the variance of the expected domestic-currency return will increase—but this will not affect the level of the expected domestic-currency return (RDC). Refer to the equation shown for the answer in Question 1 and note that Ostermann’s expected RFC has not changed. (Once again, note as well that RFX is defined with the domestic currency as the price currency.)

A and B are incorrect. An increase in the expected correlation between movements in the foreign-currency asset returns and movements in the spot rates from 0.50 to 0.80 would increase the domestic-currency return risk but would not impact the expected domestic-currency return.

Ostermann believes that currency markets are efficient and hence that long-run gains cannot be achieved from active currency management, especially after netting out management and transaction costs. She uses this philosophy to guide hedging decisions for her discretionary accounts, unless instructed otherwise by the client.

Ostermann is aware, however, that some investors hold an alternative view on the merits of active currency management. Accordingly, their portfolios have different investment guidelines. For these accounts, Guten Investments employs a currency specialist firm, Umlauf Management, to provide currency overlay programs specific to each client’s investment objectives. For most hedging strategies, Umlauf Management develops a market view based on underlying fundamentals in exchange rates. However, when directed by clients, Umlauf Management uses options and a variety of trading strategies to unbundle all of the various risk factors (the “Greeks”) and trade them separately.

Q.

Based on Ostermann’s views regarding active currency management, the percentage of currency exposure in her discretionary accounts that is hedged is most likely:

1. A.0%.
2. B.50%.
3. C.100%.

Solution

A is correct. Guten believes that, due to efficient currency markets, there should not be any long-run gains for speculating (or active management) in currencies, especially after netting out management and transaction costs. Therefore, both currency hedging and actively trading currencies represent a cost to the portfolio with little prospect of consistently positive active returns. Given a long investment horizon and few immediate liquidity needs, Guten is most likely to choose to forgo currency hedging and its associated costs.

B and C are incorrect because given a long investment horizon and little immediate liquidity needs, Guten is most likely to choose to forgo currency hedging and its associated costs. Guten believes that due to efficient currency markets there should not be any long-run gains when speculating in currencies, especially after netting out management and transaction costs.

Ostermann is aware, however, that some investors hold an alternative view on the merits of active currency management. Accordingly, their portfolios have different investment guidelines. For these accounts, Guten Investments employs a currency specialist firm, Umlauf Management, to provide currency overlay programs specific to each client’s investment objectives. For most hedging strategies, Umlauf Management develops a market view based on underlying fundamentals in exchange rates. However, when directed by clients, Umlauf Management uses options and a variety of trading strategies to unbundle all of the various risk factors (the “Greeks”) and trade them separately.

Q.

The active currency management approach that Umlauf Management is least likely to employ is based on:

1. A.volatility trading.
2. B.technical analysis.
3. C.economic fundamentals.

Solution

B is correct. Umlauf develops a market view based on underlying fundamentals in exchange rates (an economic fundamental approach). When directed by clients, Umlauf uses options and a variety of trading strategies to unbundle all of the various risk factors and trades them separately (a volatility trading approach). A market technical approach would entail forming a market view based on technical analysis (i.e., a belief that historical prices incorporate all relevant information on future price movements and that such movements have a tendency to repeat).

A is incorrect because, in using options and a variety of trading strategies to unbundle all of the various risk factors and trade them separately, Umlauf is likely to periodically employ volatility trading-based currency strategies.

C is incorrect because, in developing a market view based on underlying fundamentals in exchange rates, Umlauf does utilize an economic fundamentals approach.

Ostermann conducts an annual review for three of her clients and gathers the summary information presented in Exhibit 2.

Exhibit 2:

Select Clients at Guten Investments

Client	Currency Management Objectives
Adele Kastner – A high net worth individual with a low risk tolerance.	Keep the portfolio’s currency exposures close, if not equal to, the benchmark so that the domestic-currency return is equal to the foreign-currency return.
Braunt Pensionskasse – A large private-company pension fund with a moderate risk tolerance.	Limited discretion which allows the actual portfolio currency risk exposures to vary plus-or-minus 5% from the neutral position.
Franz Trading GmbH – An exporting company with a high risk tolerance.	Discretion with respect to currency exposure is allowed in order to add alpha to the portfolio.

Q.

Based on Exhibit 2, the currency overlay program most appropriate for Braunt Pensionskasse would:

1. A.be fully passive.
2. B.allow limited directional views.
3. C.actively manage foreign exchange as an asset class.

Chose A

Solution

B is correct. Braunt Pensionskasse provides the manager with limited discretion in managing the portfolio’s currency risk exposures. This would be most consistent with allowing the currency overlay manager to take directional views on future currency movements (within predefined bounds) where the currency overlay is limited to the currency exposures already in the foreign asset portfolio. It would not be appropriate to use a fully-passive hedging approach since it would eliminate any alpha from currency movements. Further, a currency overlay program, which considers “foreign exchange as an asset class”, would likely expose Braunt’s portfolio to more currency risk than desired given the given primary performance objectives.

A is incorrect because a directional view currency overlay program is most appropriate given the limited discretion Braunt Pensionskasse has given the manager. A fully passive currency overlay program is more likely to be used when a client seeks to hedge all the currency risk.

C is incorrect because a directional view currency overlay program is most appropriate given the limited discretion Braunt Pensionskasse has given the manager. In contrast, the concept of “foreign exchange as an asset class” allows the currency overlay manager to take currency exposure positions in any currency pair where there is value-added to be harvested.

Q.

Based on Exhibit 2, the client most likely to benefit from the introduction of an additional overlay manager is:

1. A.Adele Kastner.
2. B.Braunt Pensionskasse.
3. C.Franz Trading GmbH.

Solution

C is correct. The primary performance objective of Franz Trading GmbH is to add alpha to the portfolio, and thus has given the manager discretion in trading currencies. This is essentially a “foreign exchange as an asset class” approach. Braunt Pensionskasse and Kastner have more conservative currency strategies, and thus are less likely to benefit from the different strategies that a new overlay manager might employ.

A is incorrect because Franz Trading GmbH is more likely to benefit from the introduction of an additional overlay manager. Kastner is more likely to have a fully passive currency overlay program.

B is incorrect because Franz Trading GmbH is more likely to benefit from the introduction of an additional overlay manager. Braunt is more likely to have a currency overlay program where the manager takes a directional view on future currency movements.

Q.

Gupta interviews a currency overlay manager on behalf of Portfolio A.

The foreign currency overlay manager describes volatility-based trading, compares volatility-based trading strategies and explains how the firm uses currency options to establish positions in the foreign exchange market.

The overlay manager states:

Statement 1	“Given the current stability in financial markets, several traders at our firm take advantage of the fact that most options expire out-of-the money and therefore are net-short volatility.”
Statement 2	“Traders that want to minimize the impact of unanticipated price volatility are net-long volatility.”

Compare Statement 1 and Statement 2 and identify which best explains the view of a speculative volatility trader and which best explains the view of a hedger of volatility. Justify your response.

1 - speculative voltility trader. because it attempts to take advantage of general volatility facts of options expiring OTM by writing options

2 - hedger of volatility. The attempt to minimize impact of volaility, by net long volatility like buy put options, are example of hedging against downside risks.

Solution

Statements 1 and 2 compare differences between speculative volatility traders and hedgers of volatility. Statement 1 best explains the view of a speculative volatility trader. Speculative volatility traders often want to be net-short volatility, if they believe that market conditions will remains stable. The reason for this is that most options expire out-of-the money, and the option writer can then keep the option premium as a payment earned for accepting volatility risk. (Speculative volatility traders would want to be long volatility if they thought volatility was likely to increase.)

Statement 2 best describes the view of a hedger of volatility. Most hedgers are net-long volatility since they want to buy protection from unanticipated price volatility. Buying currency risk protection generally means a long option position. This can be thought of as paying an insurance premium for protection against exchange rate volatility.

Q.

Carnoustie Capital Management, Ltd. (CCM), a UK-based global investment advisory firm, is considering adding an emerging market currency product to its offerings.

CCM has for the past three years managed a “model” portfolio of emerging market currencies using the same investment approach as its developed economy currency products.

The risk and return measures of the “model” portfolio compare favorably with the one- and three-year emerging market benchmark performance net of CCM’s customary advisory fee and estimated trading costs.

Mindful of the higher volatility of emerging market currencies, CCM management is particularly pleased with the “model” portfolio’s standard deviation, Sharpe ratio, and value at risk (VAR) in comparison to those of its developed economy products.

Recognizing that market conditions have been stable since the “model” portfolio’s inception, CCM management is sensitive to the consequences of extreme market events for emerging market risk and return.

Evaluate the application of emerging market and developed market investment return probability distributions for CCM’s potential new product.

Solution

Emerging market currency trades are subject to relatively frequent extreme events and market stresses. Thus, return probability distributions for emerging market investments exhibit fatter tails than the normal distributions that are customarily used to evaluate developed market investment performance. Additionally, emerging market return probability distributions also have a pronounced negative skew when compared with developed market (normal) distributions.

Given these differences, risk management and control tools (such as VAR) that depend on normal distributions can be misleading under extreme market conditions and greatly understate the risks to which the portfolio is exposed. Likewise, many investment performance measures used to evaluate performance are also based on the normal distribution. As a result, historical performance evaluated by such measures as the Sharpe ratio can look very attractive when market conditions are stable, but this apparent outperformance can disappear into deep losses faster than most investors can react.

Short-term stability in emerging markets can give investors a false sense of overconfidence and thereby encourage over-positioning based on the illusion of normally distributed returns. Thus, CCM should not assume a normal distribution for its “model” emerging market portfolio. CCM should assume a fatter-tailed, negatively skewed return probability distribution better reflecting the risk exposure to extreme events.

Rosario Delgado is an investment manager in Spain. Delgado’s client, Max Rivera, seeks assistance with his well-diversified investment portfolio denominated in US dollars.

Rivera’s reporting currency is the euro, and he is concerned about his US dollar exposure. His portfolio IPS requires monthly rebalancing, at a minimum. The portfolio’s market value is USD2.5 million. Given Rivera’s risk aversion, Delgado is considering a monthly hedge using either a one-month forward contract or one-month futures contract.

Q.Determine which type of hedge instrument combination is most appropriate for Rivera’s situation. Justify your selection.

Determine which type of hedge instrument combination is most appropriate for Rivera’s situation. (Circle one.)
Static Forward	Static Futures	Dynamic Forward	Dynamic Futures
Justify your selection.

Summary

2.5mil market value, risk aversion; hedge. forward or futures, static or dynamic

ChatGPT - https://chatgpt.com/c/b80ba07d-1192-4190-9109-aff71bbc09a6

Solution - Dynamic Forward

Justify your selection.
Static vs. Dynamic Justifications: 1. Both Rivera and Delgado are risk averse. 2. The portfolio’s IPS requires monthly rebalancing. Forward vs. Futures Justifications: 1. A forward contract is less expensive. 2. A forward contract has greater liquidity.

The hedge instrument combination most appropriate for Rivera’s portfolio is a dynamic forward hedge for the reasons noted below.

First, a dynamic hedge is most appropriate here. A static hedge (i.e., unchanging hedge) will avoid transaction costs but will also tend to accumulate unwanted currency exposures as the value of the foreign-currency assets change. This characteristic will cause a mismatch between the market value of the foreign-currency asset portfolio and the nominal size of the forward contract used for the currency hedge; this is pure currency risk. Given this potential mismatch and because both Rivera and Delgado are risk averse, Delgado should implement a dynamic hedge by rebalancing the portfolio at least on a monthly basis.

Delgado must assess the cost–benefit trade-offs of how frequently to dynamically rebalance the hedge. This depends on a variety of factors (manager risk aversion, market view, IPS guidelines). The higher the degree of risk aversion, the more frequently the hedge is likely to be rebalanced back to the “neutral” hedge ratio.

A forward contract is more suitable because in comparison to a futures contract, a forward contract is more flexible in terms of currency pair, settlement date, and transaction amount. Forward contracts are also simpler than futures contracts from an administrative standpoint owing to the absence of margin requirements, reducing portfolio management expense. Finally, forward contracts are more liquid than futures for trading in large sizes because the daily trade volume for OTC currency forward contracts dwarfs those for exchange-traded futures contracts.

Rosario Delgado is an investment manager in Spain. Delgado’s client, Max Rivera, seeks assistance with his well-diversified investment portfolio denominated in US dollars.

Rivera’s reporting currency is the euro, and he is concerned about his US dollar exposure. His portfolio IPS requires monthly rebalancing, at a minimum. The portfolio’s market value is USD2.5 million. Given Rivera’s risk aversion, Delgado is considering a monthly hedge using either a one-month forward contract or one-month futures contract.

QuestionQ.

Assume Rivera’s portfolio was perfectly hedged. It is now time to rebalance the portfolio and roll the currency hedge forward one month. The relevant data for rebalancing are provided in Exhibit 1.

Exhibit 1:

Portfolio and Relevant Market Data

	One Month Ago	Today
Portfolio value of assets (USD)	2,500,000	2,650,000
USD/EUR spot rate (bid–offer)	1.1713/1.1714	1.1575/1.1576
One-month forward points (bid–offer)	9/10	6/7

Calculate the net cash flow (in euros) to maintain the desired hedge. Show your calculations.

Solution

When hedging one month ago, Delgado would have sold USD2,500,000 one month forward against the euro. Now, with the US dollar-denominated portfolio increasing in value to USD2,650,000, a mismatched FX swap is needed to settle the initial expiring forward contract and establish a new hedge given the higher market value of the US dollar-denominated portfolio.

To calculate the net cash flow (in euros) to maintain the desired hedge, the following steps are necessary:

1. Buy USD2,500,000 at the spot rate. Buying US dollars against the euro means selling euros, which is the base currency in the USD/EUR spot rate. Therefore, the bid side of the market must be used to calculate the outflow in euros. USD2,500,000 / 0.8875 = EUR2,816,901.

2. Sell USD2,650,000 at the spot rate adjusted for the one-month forward points (all-in forward rate). Selling the US dollar against the euro means buying euros, which is the base currency in the USD/EUR spot rate. Therefore, the offer side of the market must be used to calculate the inflow in euros. All-in forward rate = 1.1576 + (7/10,000) = 1.1583USD2,650,000 / 1.1583 = EUR2,287,836.

3. Therefore, the net cash flow is equal to EUR2,287,836 – EUR2,159,827 which is equal to EUR128,009.

ChatGPT - https://chatgpt.com/c/da1835d7-5e5e-4103-87f7-72116770897f

Resources:

https://www.analystforum.com/t/r10-eoc-qn-34-currency-management-rosario-delgado-item-set/145749

https://www.reddit.com/r/CFA/comments/10cltvg/reading_10_question_34/

Rosario Delgado is an investment manager in Spain. Delgado’s client, Max Rivera, seeks assistance with his well-diversified investment portfolio denominated in US dollars.

Rivera’s reporting currency is the euro, and he is concerned about his US dollar exposure. His portfolio IPS requires monthly rebalancing, at a minimum. The portfolio’s market value is USD2.5 million. Given Rivera’s risk aversion, Delgado is considering a monthly hedge using either a one-month forward contract or one-month futures contract.

Q.

Calculate the net cash flow (in euros) as of today to maintain the desired hedge.

Identify two strategies Delgado should use to earn a positive roll yield. Describe the specific steps needed to execute each strategy.

Identify two strategies Delgado should use to earn a positive roll yield.	Describe the specific steps needed to execute each strategy.

ChatGPT

https://chatgpt.com/c/a3859831-d45f-4a6d-9dfc-30ef044e408d

Strategies to Earn a Positive Roll Yield

1. Strategy 1: Rolling Forward Contracts

   • Steps:

     1. Enter a one-month forward contract to hedge the USD exposure.

     2. Upon expiry, close the existing forward contract and enter a new one-month forward contract.

     3. Continue this process monthly, aiming to roll into a more favorable forward rate each time.

   • Rationale: This strategy leverages the typically higher interest rates in the US compared to the Eurozone, resulting in a favorable forward rate that earns a positive roll yield.

2. Strategy 2: Using Currency Futures Contracts

   • Steps:

     1. Enter a one-month currency futures contract to sell USD and buy EUR.

     2. Upon expiry, close the existing futures contract and enter a new one-month futures contract.

     3. Ensure to maintain the futures position each month, benefiting from the contango structure (where futures prices are higher than spot prices).

   • Rationale: This strategy allows Rosario to lock in favorable exchange rates over time, taking advantage of the upward-sloping futures curve (contango) to earn a positive roll yield.

Solution

When hedging one month ago, Delgado would have sold USD2,500,000 one month forward against the euro. To calculate the net cash flow (in euros) today, the following steps are necessary:

1) Sell USD2,500,000 at the one-month forward rate stated in the forward contract. Selling US dollars against the euro means buying euros, which is the base currency in the USD/EUR forward rate. Therefore, the offer side of the market must be used to calculate the inflow in euros. All-in forward rate = 0.8914 + (30/10,000) = 0.8944 USD2,500,000 / 0.8944 = EUR2,795,169.95 2) Buy USD2,500,000 at the spot rate to offset the USD sold in Step 1 above. Buying the US dollar against the euro means selling euros, which is the base currency in the USD/EUR spot rate. Therefore, the bid side of the market must be used to calculate the inflow in euros. USD2,500,000 / 0.8875 = EUR2,816,901.41 3) Therefore, the net cash flow is equal to EUR2,795,169.95– EUR2,816,901.41, which is equal to a net outflow of EUR21,731.46. To maintain the desired hedge, Delgado will then enter into a new forward contract to sell the USD2,650,000. There will be no additional cash flow today arising from the new forward contract.

WTF?

Li Jiang is an international economist operating a subscription website through which she offers financial advice on currency issues to retail investors. One morning she receives four subscriber e-mails seeking guidance.

Subscriber 1	“As a French national now working in the United States, I hold US dollar-denominated assets currently valued at USD 700,000. The USD/EUR exchange rate has been quite volatile and now appears oversold based on historical price trends. With my American job ending soon, I will return to Europe. I want to protect the value of my USD holdings, measured in EUR terms, before I repatriate these funds back to France. To reduce my currency exposure I am going to use currency futures contracts. Can you explain the factors most relevant to implementing this strategy?”
Subscriber 2	“I have observed that many of the overseas markets for Korean export goods are slowing, while the United States is experiencing a rise in exports. Both trends can combine to possibly affect the value of the won (KRW) relative to the US dollar. As a result, I am considering a speculative currency trade on the KRW/USD exchange rate. I also expect the volatility in this exchange rate to increase.”
Subscriber 3	“India has relatively high interest rates compared to the United States and my market view is that this situation is likely to persist. As a retail investor actively trading currencies, I am considering borrowing in USD and converting to the Indian rupee (INR). I then intend to invest these funds in INR-denominated bonds, but without using a currency hedge.”
Subscriber 4	“I was wondering if trading in emerging market currencies provides the more opportunities for superior returns through active management than trading in Developed Market currencies.”

Q.

For Subscriber 1, the most significant factor to consider would be:

1. A.margin requirements.
2. B.transaction costs of using futures contracts.
3. C.different quoting conventions for future contracts.

Solution

A is correct. Exchange-traded futures contract not only have initial margin requirements, they also have daily mark-to-market and, as a result, can be subject to daily margin calls.

Market participants must have sufficient liquidity to meet margin calls, or have their positions involuntarily liquidated by their brokers.

Note that the risk of daily margin calls is not a feature of most forwards contracts; nor is initial margin. (However, this is changing among the largest institutional players in FX markets as many forward contracts now come with what are known as Collateral Support Annexes—CSAs—in which margin can be posted. Posting additional margin would typically not be a daily event, however, except in the case of extreme market moves.)

B is incorrect because futures contracts have low transactions costs.

C is incorrect because whether the EUR is the price or the base currency in the quote will not affect the hedging process. In fact, on the CME the quote would be the market-standard USD/EUR quote, with the EUR as the base currency.

Q.

For Subscriber 2, and assuming all of the choices relate to the KRW/USD exchange rate, the best way to implement the trading strategy would be to:

1. A.write a straddle.
2. B.buy a put option.
3. C.use a long NDF position.

My immediate response is long straddle or long strangle -> A is wrong but... long deeper, actually

"I have observed that many of the overseas markets for Korean export goods are slowing, while the United States is experiencing a rise in exports. Both trends can combine to possibly affect the value of the won (KRW) relative to the US dollar"

so Korean exports slowing, US exports rising, means demand for KRW decreases, and USD increases, so KRW/USD will rise.

here, answers could also be long call KRW/USD -> B is wrong;

so a possible answer is also long forward.

look at C - use a long NDF position. NDF = Non-Deliverable Forward ' This would require a long forward position in a forward contract, but as a country with capital controls, a NDF would be used instead.'

Solution

C is correct. Based on predicted export trends, Subscriber 2 most likely expects the KRW/USD rate to increase (i.e., the won—the price currency—to depreciate relative to the USD). This would require a long forward position in a forward contract, but as a country with capital controls, a NDF would be used instead. (Note: While forward contracts offered by banks are generally an institutional product, not retail, the retail version of a non-deliverable forward contract is known as a “contract for differences” (CFD) and is available at several retail FX brokers.)

A is incorrect because Subscriber 2 expects the KRW/USD rate to increase. A short straddle position would be used when the direction of exchange rate movement is unknown and volatility is expected to remain low.

B is incorrect because a put option would profit from a decrease of the KRW/USD rate, not an increase (as expected). Higher volatility would also make buying a put option more expensive.

Q.

Which of the following market developments would be most favorable for Subscriber 3’s trading plan?

1. A.A narrower interest rate differential.
2. B.A higher forward premium for INR/USD.
3. C.Higher volatility in INR/USD spot rate movements.

Solution

B is correct. Subscriber 3’s carry trade strategy is equivalent to trading the forward rate bias, based on the historical evidence that the forward rate is not the center of the distribution for the spot rate.

Applying this bias involves buying currencies trading at a forward discount and selling currencies trading at a forward premium.

So a higher forward premium on the lower yielding currency—the USD, the base currency in the INR/USD quote—would effectively reflect a more profitable trading opportunity.

That is, a higher premium for buying or selling the USD forward is associated with a lower US interest rate compared to India.

This would mean a wider interest rate differential in favor of Indian instruments, and hence potentially more carry trade profits.

A is incorrect because Subscriber 3’s carry trade strategy depends on a wide interest rate differential between the high-yield country (India) and the low-yield country (the United States). The differential should be wide enough to compensate for the unhedged currency risk exposure.

C is incorrect because a guide to the carry trade’s riskiness is the volatility of spot rates on the involved currencies, with rapid movements in exchange rates often associated with a panicked unwinding of carry trades. All things being equal, higher volatility is worse for carry trades.

Q.

Jiang’s best response to Subscriber 4 would be that active trading in trading in emerging market currencies:

1. A.typically leads to return distributions that are positively skewed.
2. B.should not lead to higher returns because FX markets are efficient.
3. C.often leads to higher returns through carry trades, but comes with higher risks and trading costs.

Chose B coz seemed to be politically correct answer

Not A coz it should be negatively skewed?

C... hmm hesitated

Solution

C is correct. Emerging market currencies are often the investment currencies in the carry trade. This reflects the higher yields often available in their money markets compared to Developed Market economies (funding currencies are typically low-yield currencies such as the JPY). This can lead to higher holding returns, but these higher returns can also come with higher risks: carry trades are occasionally subject to panicked unwinds in stressed market conditions. When this occurs, position exit can be made more difficult by market illiquidity and higher trading costs (wider bid/offer spreads). The leverage involved in the carry trade can magnify trading losses under these circumstances.

A is incorrect because return distributions are often negatively skewed, reflecting the higher event risk (panicked carry trade unwinds, currency pegs being re-set, etc.) associated with the carry trade.

B is incorrect because although FX markets are typically efficient (or very close thereto) this does not mean that higher returns are not available. The key question is whether these are abnormally high risk-adjusted returns. Higher return in an efficient market comes with higher risk. The higher (short-term) return in the carry trade reflects the risk premia for holding unhedged currency risk, in the context of a favorable interest rate differential.

Renita Murimi is a currency overlay manager and market technician who serves institutional investors seeking to address currency-specific risks associated with investing in international assets.

Her firm also provides volatility overlay programs.

She is developing a volatility-based strategy for Emil Konev, a hedge fund manager focused on option trading.

Konev seeks to implement an “FX as an asset class” approach distinct to his portfolio to realize speculative gains and believes the long-term strength of the US dollar is peaking.

QuestionQ.

Describe how a volatility-based strategy for Konev would most likely contrast with Murimi’s other institutional investors. Justify your response.

Konev volatility based strategy involves speculative posiions, such as writing call option on US dollar as it's peaking to gain premium for options expire OTM; whereas other institutional investors, they're trying to address currency risks, with the aim to protect profits than gaining alpha from the positions.

Solution

In currency markets, volatility is not constant, nor are its movements completely random. Instead, volatility is determined by a wide variety of underlying factors, both fundamental and technical, for which a trader can express an opinion.

Movements in volatility are cyclical and typically subject to long periods of relative stability punctuated by sharp upward spikes in volatility as markets come under stress. Speculative volatility traders among overlay managers often want to be net short volatility because most options expire out of the money and the option writer then gets to keep the premium without delivery of the underlying currency pair.

Ideally these traders would want to flip their position and be long volatility ahead of the volatility spikes, but these episodes can be notoriously difficult to time.

Most hedgers, in contrast, typically run option positions that are net long volatility because they are buying protection from the unanticipated price volatility.

In this case, Konev would most likely be interested in speculative gains on US dollar weakness, while the other institutional clients would be hedgers seeking to minimize trading risks.

The concept of foreign exchange as an asset class for Konev will most likely permit Murimi to take foreign exchange exposure in any currency pair where there is additional value to capture.

A volatility-based strategy for Konev would typically be net short, as opposed to net long, volatility to earn the related risk premium for absorbing volatility risk.

In contrast, the institutional investors, as hedgers in managing net long volatility positions, would be exposed to the time decay of an option’s time value.

Renita Murimi is a currency overlay manager and market technician who serves institutional investors seeking to address currency-specific risks associated with investing in international assets. Her firm also provides volatility overlay programs. She is developing a volatility-based strategy for Emil Konev, a hedge fund manager focused on option trading. Konev seeks to implement an “FX as an asset class” approach distinct to his portfolio to realize speculative gains and believes the long-term strength of the US dollar is peaking.

Q.

Discuss how Murimi can use her technical skills to devise the strategy.

Pay attention that Murimi is a market TECHNICIAN - te hnical analysis

write OTM call options if USD is peaking and won't go higher;

Solution

In forming a market view on such turning points in future exchange rate movements (e.g., peaking in the US dollar) or timing-related position entry and exit points, market technicians follow three principles:

(1) Historical price data can be helpful in projecting future movements,

(2) historical price patterns have a tendency to repeat and identify profitable trade opportunities, and

(3) technical analysis attempts to determine not where market prices should trade but where they will trade.

Thus, when devising a volatility strategy, Murimi can use her technical skills to time entry and exit points of positions. She can identify patterns in the historical price data on the US dollar, such as when it was overbought or oversold, meaning it has trended too far in one direction and is vulnerable to a trend reversal. She would appropriately position US dollar trades to maximize potential returns from volatility shifts that could be associated with US dollar exchange rate movements.S

The fund manager of Portfolio B believes that setting up a full currency hedge requires a simple matching of the current market value of the foreign-currency exposure in the portfolio with an equal and offsetting position in a forward contract.

Q.

Explain how the hedge, as described by the fund manager, will eventually expose the portfolio to currency risk.

Solution

In practice, matching the current market value of the foreign-currency exposure in the portfolio with an equal and offsetting position in a forward contract is likely to be

• ineffective over time because the market value of foreign-currency assets will change with market conditions.

A static hedge (i.e., an unchanging hedge) will

• tend to accumulate unwanted currency exposures as the value of the foreign-currency assets change.

This will result in a mismatch between the market value of the foreign-currency asset portfolio and the nominal size of the forward contract used for the currency hedge (resulting in currency risk).

For this reason, the portfolio manager will generally need to implement a dynamic hedge by rebalancing the portfolio periodically.

The fund manager of Portfolio B believes that setting up a full currency hedge requires a simple matching of the current market value of the foreign-currency exposure in the portfolio with an equal and offsetting position in a forward contract.

QuestionQ.

Recommend an alternative hedging strategy that will keep the hedge ratio close to the target hedge ratio. Identify the main disadvantage of implementing such a strategy.

dynamic hedging, continously adjust hedge positions to match current value of foreign currency exposure

Main disadvantages

• transactional costs - each adjustment may incur commission charges or broker fees

• Operational complexity - requires more sophisticated tracking and trading system, and skilled personnel to execute and oversee the strategy

ChatGPT ^ - https://chatgpt.com/c/d628fd5c-28f1-4ccf-9f21-688bf32c9a05

Solution

The fund manager should implement a dynamic hedging approach. Dynamic hedging requires rebalancing the portfolio periodically. The rebalancing would require adjusting some combination of the size, number, and maturities of the foreign-currency contracts.

Although rebalancing a dynamic hedge will keep the actual hedge ratio close to the target hedge ratio, it has the disadvantage of increased transaction costs compared to a static hedge.

Rika Björk runs the currency overlay program at a large Scandinavian investment fund, which uses the Swedish krona (SEK) as its reporting currency. She is managing the fund’s exposure to GBP-denominated assets, which are currently hedged with a GBP 100,000,000 forward contract (on the SEK/GBP cross rate, which is currently at 10.6875 spot). The maturity for the forward contract is December 1, which is still several months away. However, since the contract was initiated the value of the fund’s assets has declined by GBP 7,000,000. As a result, Björk wants to rebalance the hedge immediately

Q.

To rebalance the SEK/GBP hedge, and assuming all instruments are based on SEK/GBP, Björk would buy:

1. A.GBP 7,000,000 spot.
2. B.GBP 7,000,000 forward to December 1.
3. C.SEK 74,812,500 forward to December 1.

Solution

B is correct. The GBP value of the assets has declined, and hence the hedge needs to be reduced by GBP 7,000,000. This would require buying the GBP forward to net the outstanding (short) forward contract to an amount less than GBP 100,000,000.

A is incorrect because to rebalance the hedge (reduce the net size of the short forward position) the GBP must be bought forward, not with a spot transaction.

C is incorrect because the GBP must be bought, not sold. Buying SEK against the GBP is equivalent to selling GBP. Moreover, the amount of SEK that would be sold forward (to buy GBP 7,000,000 forward) would be determined by the forward rate, not the spot rate (7,000,000 × 10.6875 = 74,812,500).

Next Björk turns her attention to the fund’s Swiss franc (CHF) exposures. In order to maintain some profit potential Björk wants to hedge the exposure using a currency option, but at the same time, she wants to reduce hedging costs. She believes that there is limited upside for the SEK/CHF cross rate.

Q.

Given her investment goals and market view, and assuming all options are based on SEK/CHF, the best strategy for Björk to manage the fund’s CHF exposure would be to buy an:

1. A.ATM call option.
2. B.ITM call option and write an OTM call option.
3. C.OTM put option and write an OTM call option.

Hedge -> buy put option

Limited upside -> Write call option

Solution

C is correct. The fund holds CHF-denominated assets and hence Björk wants to protect against a depreciation of the CHF against the SEK, which would be a down-move in the SEK/CHF cross rate. An OTM put option provides some downside protection against such a move, while writing an OTM call option helps reduce the cost of this option structure. Note that Björk does not expect that the SEK/CHF rate will increase, so this option (in her view) will likely expire OTM and allow her to keep the premia. This hedging structure is known as a short risk reversal (or a collar) and is a popular hedging strategy.

A is incorrect because the ATM call option will not protect against a decrease in the SEK/CHF rate. An ATM option is also expensive (compared to an OTM option). Note that Björk does not expect the SEK/CHF rate to increase, so would not want a long call option position for this rate.

B is incorrect because this structure is expensive (via the long ITM call option) and does not protect against a decrease in the SEK/CHF rate.

Björk then examines the fund’s EUR-denominated exposures. Due to recent monetary tightening by the Riksbank (the Swedish central bank) forward points for the SEK/EUR rate have swung to a premium. The fund’s EUR-denominated exposures are hedged with forward contracts.

Q.

Given the recent movement in the forward premium for the SEK/EUR rate, Björk can expect that the hedge will experience higher:

1. A.basis risk.
2. B.roll yield.
3. C.premia income.

Solution

B is correct. To hedge the EUR-denominated assets Björk will be selling forward contracts on the SEK/EUR cross rate. A higher forward premium will result in higher roll return as Björk is selling the EUR forward at a higher all-in forward rate, and closing out the contract at a lower rate (all else equal), given that the forward curve is in contango.

A is incorrect because Björk is hedging EUR-denominated assets with a EUR-denominated forward contract. While it is true that the gap between spot and forward rates will be higher the higher the interest rate differential between countries, this gap (basis) converges to zero near maturity date, when the forward contracts would be rolled.

C is incorrect because forward contracts do not generate premia income; writing options does.

ChatGPT ^ - https://chatgpt.com/c/6bcf40ea-b5d5-48a1-950a-4fb2490d6b6a

Finally Björk turns her attention to the fund’s currency exposures in several emerging markets.

The fund has large positions in several Latin American bond markets, but Björk does not feel that there is sufficient liquidity in the related foreign exchange derivatives to easily hedge the fund’s Latin American bond markets exposures.

However, the exchange rates for these countries, measured against the SEK, are correlated with the MXN/SEK exchange rate. (The MXN is the Mexican peso, which is considered to be among the most liquid Latin American currencies).

Björk considers using forward positions in the MXN to cross-hedge the fund’s Latin American currency exposures.

QuestionQ.

The most important risk to Björk’s Latin American currency hedge would be changes in:

1. A.forward points.
2. B.exchange rate volatility.
3. C.cross-currency correlations.

Solution

C is correct. A cross hedge exposes the fund to basis risk; that is, the risk that the hedge fails to protect against adverse currency movements because the correlations between the value of the assets being hedged and the hedging instrument change.

A is incorrect because movements in forward points (and hence roll yield) would be of secondary importance compared to the basis risk of a cross hedge.

B is incorrect because exchange rate volatility would not necessarily affect a hedge based on forward contracts, as long as the correlations between the underlying assets and the hedge remained stable. Although relevant, volatility in itself is not the “most” important risk to consider for a cross-hedge. (However, movements in volatility would affect hedges based on currency options.)

HNW Worldwide Inc. (HNW) is a wealth management company located in Chicago that specializes in very-high- and ultra-high-net worth clients.

Pierre Fournier, a currency specialist at the company, is reviewing the file of a long-time client, Alex Testa, an American.

Testa is a former engineer in the plastics industry who has been very successful in identifying potential takeover candidates during the consolidation of the plastics and packaging industry that has been occurring since about 2001.

As US opportunities declined in the plastics industry, Testa began to consider foreign investments. In the fall of 2008, he acquired a position in a South African plastics processor.

Although the foreign currency return on the investment was impressive, his domestic return was substantially negative because of the foreign currency change against the US dollar.

HNW Worldwide Inc. (HNW) is a wealth management company located in Chicago that specializes in very-high- and ultra-high-net worth clients. Pierre Fournier, a currency specialist at the company, is reviewing the file of a long-time client, Alex Testa, an American. Testa is a former engineer in the plastics industry who has been very successful in identifying potential takeover candidates during the consolidation of the plastics and packaging industry that has been occurring since about 2001.

Testa’s association with HNW began in 2009 as he was about to undertake a position in a Spanish packaging company. Fournier used Testa’s description of his investment process to develop an investment policy statement (IPS) for him, which included the following objectives and constraints:

• Testa fully believed in his investment process, which was to be the primary focus in generating investment returns.

• Testa was not overly risk averse.

• Only the major currencies against the US dollar were likely to be used for the next several years.

• Currency exposure would usually not extend beyond a six-month period.

• Negative currency moves were to be rebalanced monthly if they exceeded 3% of the initial exposure.

• Currency options could be used selectively—only if a strong market view was held when rebalancing a hedged position that had already proved profitable.

• The anticipated positions would not have any associated income or liquidity requirements.

• The cost of any hedging strategies used should be minimized and not materially affect the otherwise unhedged asset return.

In regard to the anticipated currency movements related to the Spanish packaging company investment, Fournier told Testa that HNW was forecasting that the euro was likely to appreciate against the US dollar in the next six months.

In terms of the objectives and constraints that were incorporated into Testa’s IPS, the one that best explains the initial euro exposure of the Spanish investment in 2009 is the one related to his:

1. A.risk aversion.
2. B.return objective.
3. C.liquidity constraint.

Solution

B is correct. The main goal of Testa’s investment program is the realization of returns based on his perceived superior ability to discover merger and acquisition targets. The position was fully hedged even though both he and his adviser believed that the euro was likely to appreciate over the investment horizon; there was no attempt to exploit that belief either with futures or options (although the use of options was restricted to strong market views at the time of rebalancing of an already winning position).

A is incorrect. Testa is not overly risk averse; his main focus is on the return generated from his investment process.

C is incorrect. Testa’s investment program did not impose any liquidity or income needs on the position.

Currency Management: An Introduction Learning Outcome

1. Formulate an appropriate currency management program given financial market conditions and portfolio objectives and constraints

In regard to the anticipated currency movements related to the Spanish packaging company investment, Fournier told Testa that HNW was forecasting that the euro was likely to appreciate against the US dollar in the next six months.

Testa agreed with HNW’s assessment of the future course of the USD/EUR exchange rate. His conclusion was derived from assessing various analysts’ reports and was centered on the following three reasons:

1. real interest rates were higher in euro-based countries,

2. the potential default of several euro-based countries from their excessive debt loads would lead to strong support measures from the IMF and the European Central Bank, and

3. the US balance of trade deficit with euro-based countries had continued to decline in the past several years and was expected to continue to decline.

Which of Testa’s reasons for the future course of the USD/EUR exchange rate in 2009 is most consistent with HNW’s assessment?

1. A.Reason 1
2. B.Reason 2
3. C.Reason 3

Solution

A is correct. HNW’s assessment was that the euro was likely to appreciate against the US dollar within the next six months. Reason 1, higher real rates in euro-based countries, is consistent with an appreciation of the euro. Higher euro rates will attract “foreign” investors and drive up demand for the euro as they acquire those investments.

B is incorrect. Reason 2, the potential default of several euro-based countries from their excessive debt loads, would result in a lower foreign risk premium (i.e., the US dollar would be less risky) and should lead to a depreciation of the euro.

C is incorrect. Reason 3, a decline in the US trade deficit (i.e., net exports), means that for the United States, imports decreased relative to exports, resulting in lower demand for the euro, and it should weaken relative to the US dollar.

Currency Management: An Introduction Learning Outcome

1. Describe how changes in factors underlying active trading strategies affect tactical trading decisions

The Spanish investment involved Testa acquiring 200,000 shares of a packaging company at EUR90 per share. He decided to fully hedge the position with a six-month USD/EUR forward contract. Details of the euro hedge at initiation and three months later are provided in Exhibit 1. Three months after the purchase, the shares had increased to EUR100 each, but Testa, believing that a still higher price was likely, maintained the position. He also indicated that he did not anticipate having to roll the hedge forward at its maturity. Both he and Fournier believed that further appreciation of the euro was quite likely, and the increase in the notional size of the position was hedged using currency options. They based their choices on the information provided in Exhibit 2.

Exhibit 1

2009 Spot and Forward USD/EUR Quotes (Bid-Offer) and Annualized Libor Rates

Maturity	At Initiation	Three Months Later	At Maturity
Spot (USD/EUR)	1.3935/1.3983	1.4106/1.4210	1.4189/1.4289
3-month forward	–8.1/–7.6	–21.6/–21.0
6-month forward	–19.0/–18.3		–27.0/–26.2
USD Libor		1.266%
EUR Libor		1.814%

Using Exhibit 1, if the Spanish shares had been sold after three months, the cash outflow (in US dollars) required to close out the forward contract would have been closest to:

1. A.489,182.
2. B.489,850.
3. C.491,400.

200000 shares, EUR 90 per share, fully hedge with 6-mth USD/EUR forward;

3mths later EUR100 per share

200000*90 = 18000000 EUR = long 18m EUR

hedge = sell EUR; = exchange at 18m * 1.3935 - 0.00081 = 18m * 1.39 = 1.3927

sell at 25068600 USD ?

hedge forward rate = sell 18000000 forward, at USD/EUR

Got totally wrong

Solution

B is correct.

Step 1 - understand the position

The initial foreign asset position was EUR18 million: 200,000 shares × EUR90/share.

Step 2 - Cal hedge position to be sold; get correct bid exchange rate

The six-month forward contract would have been sold using the bid of the base currency (euro) at an all-in forward rate of 1.3935 – 19/10,000 = 1.3916 USD/EUR.

Step 3 - 3 months later close the position by buying 3-month forward contract (remaining time); get the correct Ask currency

If the position had been closed in three months, a three-month forward contract would have to be purchased at the offer of the base currency at an all-in forward rate of 1.4210 – 21/10,000 = 1.4189 USD/EUR.

Step 4 - Cal culate the cash outflow by diff of exchange rate times value to get settlement cash flow

The cash outflow at settlement would have been EUR18 million × (1.4189 – 1.3916) USD/EUR = USD491,400.

Step 5 - Last step, discount back using US libor rate

This amount needs to be discounted by three months at the US dollar Libor rate: 491,400/(1 + 0.01266 × 90/360) = USD489,850.

A is incorrect. The euro Libor rate is used to discount the settlement cash flow: 491,400/(1 + 0.01814 × 90/360) = USD489,182.

C is incorrect. It uses the settlement cash flow, ignoring any discounting: USD491,400.

Currency Management: An Introduction Learning Outcome

1. Analyze the effects of currency movements on portfolio risk and return

In 2014, Testa notified Fournier that he anticipated taking a position in a plastics producer located in India. Fournier warned him that the Indian rupee (INR) was a restricted currency and that currency management would not be as simple as in the other transactions handled previously. Fournier said that non-deliverable forwards (NDFs) on the rupee were available, as they were for the currencies of other developing countries. When asked how non-deliverable forwards differed from the contracts they had used in the past, Fournier responded:

• NDFs are cash settled in the non-controlled currency of the currency pair,

• NDFs have greater credit risk associated with them than outright forward contracts because the central banks in most developing countries are not as strong as they are in developed countries, and

• the pricing of NDFs may differ from what is expected on the basis of arbitrage conditions.

Which of Fournier’s 2014 comments about non-deliverable forwards (NDFs) is least accurate? The one concerning:

1. A. pricing.

2. B. credit risk.

3. C. settlement.

Solution

B is correct. Fournier’s statement regarding credit risk is incorrect. The credit risk does not relate to the central bank of the developing country but, rather, the counterparty risk faced in the contract. The credit risk underlying an NDF is lower than an outright forward contract since the notional size of the contract is not exchanged at settlement, but only the non-controlled currency amount by which the notional size of the controlled currency has changed over the life of the contract—that is, the change in the controlled currency times the notional size converted to the non-controlled currency at the spot rate on the settlement date.

the greater credit risk associated with NDFs is more about the counterparty risk rather than the central banks. NDFs involve settlement between counterparties, not directly with central banks, and the main risk is the ability of the counterparty to fulfill the contract.

A is incorrect. Fournier’s statement regarding pricing of NDFs is correct. When capital controls exist, the free cross-border flow of capital that ensures the arbitrage condition underlying covered interest rate parity does not function consistently, and so the pricing of NDFs may differ from what is expected under arbitrage conditions.

C is incorrect. Fournier’s statement regarding settlement of NDFs is correct. Non-deliverable forwards exist in situations involving capital controls on one of the currencies. The controlled currency cannot be physically settled (i.e., not delivered or received), but instead it is cash settled in the non-controlled currency.

Currency Management: An Introduction Learning Outcome

1. Discuss challenges for managing emerging market currency exposures

ChatGPT (correct) - https://chatgpt.com/c/f490bce2-ce85-46db-9820-c4664f58eeb9

In 2015, Testa informed Fournier that he had taken large positions in both a New Zealand firm and an Australian packaging firm. The positions were roughly equal in size in terms of the US dollar. Fournier informed Testa that the correlation between USD/AUD and USD/NZD was approximately 0.85. Given the size of the positions, Testa indicated that he wished to minimize any foreign exchange exposure.

Question

The most appropriate hedging strategy for the 2015 positions, in keeping with Testa’s wishes, is based on a:

1. A.direct hedge on each currency separately.
2. B.cross-hedge of the two currencies in the portfolio.
3. C.minimum-variance hedge of the two currencies in the portfolio.

Solution

A is correct. A direct hedge on each currency is the most appropriate strategy for the long positions in the Australian and New Zealand dollar. The high correlation between the currencies does not help here because the investor will be using forward contracts to sell both of these currencies. The high correlation between the currencies could have been exploited with a cross-hedge or a minimum-variance hedge if one of the foreign assets was held long and the other short.

B is incorrect. The high correlation between the currencies could have been exploited with a cross-hedge or a minimum-variance hedge if one of the foreign assets was held long and the other short.

C is incorrect. The high correlation between the currencies could have been exploited with a cross-hedge or a minimum-variance hedge if one of the foreign assets was held long and the other short. Although a minimum hedge portfolio can be constructed without simultaneous long and short positions, the greatest risk reduction (which Testa desires) would arise if that were to occur.

Currency Management: An Introduction Learning Outcome

1. Describe the use of cross- hedges, macro- hedges, and minimum-variance- hedge ratios in portfolios exposed to multiple foreign currencies

The Spanish investment involved Testa acquiring 200,000 shares of a packaging company at EUR90 per share. He decided to fully hedge the position with a six-month USD/EUR forward contract. Details of the euro hedge at initiation and three months later are provided in Exhibit 1. Three months after the purchase, the shares had increased to EUR100 each, but Testa, believing that a still higher price was likely, maintained the position. He also indicated that he did not anticipate having to roll the hedge forward at its maturity. Both he and Fournier believed that further appreciation of the euro was quite likely, and the increase in the notional size of the position was hedged using currency options. They based their choices on the information provided in Exhibit 2.

Exhibit 1

2009 Spot and Forward USD/EUR Quotes (Bid-Offer) and Annualized Libor Rates

Maturity	At Initiation	Three Months Later	At Maturity
Spot (USD/EUR)	1.3935/1.3983	1.4106/1.4210	1.4189/1.4289
3-month forward	–8.1/–7.6	–21.6/–21.0
6-month forward	–19.0/–18.3		–27.0/–26.2
USD Libor		1.266%
EUR Libor		1.814%

If the 2009 forward hedge had been rolled forward at its maturity, using Exhibit 1, the roll yield would most likely have been:

1. A.negative, but the currency change made it less negative.
2. B.positive, but the currency change reduced some of this effect.
3. C.negative, and the currency change made it even more negative.

Solution

C is correct. In implementing the hedge, euros (the base currency) must be sold against the US dollar. The base currency is selling at a discount and thus would “roll up the curve” as the contract approaches maturity. Settlement of the forward contract would entail buying euros at a higher price—that is, selling low and buying high—resulting in a negative roll yield. Since the euro has appreciated by the time the hedge needs to be extended, this tends to further increase the cost of euros to settle the original contract and makes the roll yield even more negative—that is, sell low, buy even higher.

A and B are incorrect for the reasons stated above.

Currency Management: An Introduction Learning Outcome

1. Describe how forward contracts and FX (foreign exchange) swaps are used to adjust hedge ratios

ChatGPT (Correct) - https://chatgpt.com/c/c8daf632-f90c-4091-b41c-7998a72a2064

The first client is Gilvan Araujo Dias, a high-net-worth client who has given Sabanai responsibility for managing his foreign investments, which consist of equity investments in the United Kingdom and Germany. His other assets consist of equity and corporate bond investments in Brazil. Exhibit 1 summarizes information on Dias’s foreign portfolio holdings and exchange rates.

Exhibit 1

Gilvan Araujo Dias, Information on Foreign Asset Holdings and Exchange Rates

	UK Assets	German Assets	Spot Exchange Rates
Date	Value in GBP	Value in EUR	BRL/GBP	BRL/EUR
1/1/2013	83,400,000	55,000,000	3.8729	3.0359
1/1/2014	86,000,000	51,000,000	4.1025	3.5142

Dias has asked whether it would be appropriate for him to hedge his foreign currency exposure. Campos raises the issue with Traldi and Peixaria.

Traldi responds, “In the short run, if the correlation between foreign asset returns and foreign currency returns is negative, then there may be a need to hedge all foreign currency exposure.

Alternatively, one could implement a currency overlay program in which the currency exposure is fully hedged and currency alpha is generated separately. This currency overlay strategy will only be successful in adding value to the portfolio if the currency alpha has a high correlation with Brazilian equities and corporate bonds.”

In her response regarding hedging foreign currency exposure in Dias’s portfolio, Traldi is most likely:

1. A.incorrect about the correlations, but correct about the currency overlay program.
2. B.incorrect about the correlations and the currency overlay program.
3. C.correct about the correlations and the currency overlay program.

Solution

B is correct. Traldi is incorrect about the correlations and the currency overlay program.

In the short run, if the correlation between foreign currency asset returns and foreign currency returns is negative, then there may be no need to hedge all foreign currency exposure because some currency exposure is desirable from a portfolio diversification perspective. (Cross Hedge ?)

Regarding the currency overlay program, it will add value to the portfolio only if the currency alpha has a low correlation with other asset classes in the portfolio (i.e., Brazilian equities and corporate bonds).

A is incorrect. Traldi is incorrect with regard to correlations and the currency overlay program.

C is incorrect. Traldi is incorrect with regard to correlations and the currency overlay program.

Currency Management: An Introduction Learning Outcome

1. Discuss strategic choices in currency management

The second client, BC Fundos de Pensao (BC), manages pension funds for numerous local companies and has currency exposure to the USD, the EUR, and the GBP. BC wants Sabanai to provide guidance on using active currency management strategies for the portfolios they manage. Peixaria has been assigned this task and has collected information on one-year yield levels in the United States, United Kingdom, and Eurozone, as well as one-year implied volatility for various currency pairs extracted from option pricing models. This information is provided in Exhibit 2.

Exhibit 2

One-Year Yield Levels and Implied Volatilities

Panel A
Country	One-Year Yield
United States	0.05%
United Kingdom	0.40%
Eurozone	0.11%
Panel B
Currency Pair	One-Year Implied Volatility
USD/GBP	5.50%
GBP/EUR	7.50%
USD/EUR	9.50%

Based on the information in Exhibit 2, it would be best for Sabanai to implement a carry trade for BC by borrowing in:

1. A.USD and investing in GBP.
2. B.GBP and investing in USD.
3. C.EUR and investing in GBP.

Solution

A is correct. An appropriate active currency management strategy that may add value to BC’s portfolios would be to borrow in USD and invest in GBP. The spread in yields is widest between the United Kingdom and the United States, and the USD/GBP currency pair has the lowest implied volatility, which is better for a carry trade.

B is incorrect. UK interest rates are the highest, so the GBP would be an appropriate currency to invest, not to borrow. US interest rates are the lowest, so the USD would be an appropriate funding currency, not an investment currency.

C is incorrect. The Eurozone has higher one-year yield levels compared to the US, so this would not be the appropriate funding currency. Furthermore, one-year implied volatility for the Eurozone is the highest, which does not benefit a carry trade.

Currency Management: An Introduction Learning Outcome

1. Compare active currency trading strategies based on economic fundamentals, technical analysis, carry-trade, and volatility trading

Peixaria indicates that his research suggests that the USD/EUR currency pair will become more volatile over the near term. He recommends that BC implement an options-based strategy using USD/EUR options to profit from the expected increase in volatility.

In regard to using USD/EUR options, Peixaria is least likely to recommend a strategy to go:

1. A.long an equal number of 25-delta puts and calls.
2. B.long an equal number of 50-delta puts and calls.
3. C.short an equal number of 15-delta puts and calls.

Solution

C is correct. A short strangle (short an equal number of 15-delta calls and puts) would only be appropriate if volatility is expected to be low. The expectation is for increased volatility, so the long strangles would be more appropriate. A strategy of taking long positions on an equal number of 50-delta calls and 50-delta puts (i.e., a 50-delta straddle) is an appropriate way to take advantage of expected increased volatility in the USD/EUR currency pair. However, 50-delta calls and puts are at-the-money options and are more expensive than out-of-the-money options, such as 25-delta calls and puts (a 25-delta strangle).

A is incorrect. A long 25-delta strangle is appropriate if you expected increased volatility. This strategy is a cheaper than the 50-delta strangle because 50-delta calls and puts are at-the-money options and are more expensive than out-of-the-money options such as 25-delta calls and puts (a 25-delta strangle).

B is incorrect. A long 50-delta strangle (long 50-delta calls and puts) would be appropriate if you expected high volatility.

Currency Management: An Introduction Learning Outcome

1. Compare active currency trading strategies based on economic fundamentals, technical analysis, carry-trade, and volatility trading

The third client is Fundo do Brasil (FB), a Brazilian sovereign wealth fund. FB has long equity positions in Australian and Swiss equities. Spot and forward market currency information for AUD and CHF is provided in Exhibit 3. FB managers have asked Campos for advice on whether it would be appropriate to hedge the currency exposure with forward contracts in AUD and CHF. Campos indicates that she will examine the use of forward contracts to hedge currency exposure.

Exhibit 3

Spot and Forward Rates for AUD and CHF

Currency Pair	Current Spot Rate	Six-Month Forward Rate	Six-Month Forecast Spot Rate
BRL/AUD	2.1046	2.1523	2.0355
BRL/CHF	2.5309	2.4641	2.5642

Traldi suggests that the use of put options might be a better way to hedge currency exposure. Campos responds that there are better options-based strategies that can exploit market views and reduce hedging costs. She suggests the following strategies:

• Strategy 1: For AUD exposure, the appropriate strategy is to be long put options at a strike price of 2.1046, short put options with a strike price 2.1006, and short call options with a strike price of 2.1456.

• Strategy 2: For CHF exposure, the appropriate strategy is to be long put options at a strike price of 2.5309, short put options with a strike price 2.5049, and short call options with a strike price of 2.5669.

Based on the information provided in Exhibit 3, the most appropriate risk neutral strategy is for FB to:

1. A.over-hedge AUD and not hedge CHF.
2. B.under-hedge AUD and over-hedge CHF.
3. C.under-hedge CHF and not hedge AUD.

Solution

A is correct. Because of equity investments in Australia and Switzerland, FB has long currency exposure to AUD and CHF. The appropriate risk-neutral strategy is to over-hedge (hedge ratio > 1) AUD and not hedge CHF. The AUD is selling at a forward premium of 2.27%, which means that the expected roll yield for a short hedge in AUD is 2.27%. Furthermore, the AUD is expected to depreciate by 3.28%, which means the short position in the AUD gains 3.28%. Thus, a short hedge of the AUD is appropriate. The CHF is at a forward discount of 2.64%, which means that the expected roll yield for a short hedge of CHF is –2.64%. The CHF is expected to appreciate 1.32%, which means that a short position in CHF would lose 1.32%. Thus, in this instance it would not be appropriate to hedge the CHF.

Hedge here == sell forward

so expecting spot drops, sell more

Currency Pair	Current Spot Rate	Six-Month Forward Rate	Six-Month Forecast Spot Rate	Forward Premium/Discount	Spot Appreciation/Depreciation
BRL/AUD	2.1046	2.1523	2.0355	2.27%	–3.28%
BRL/CHF	2.5309	2.4641	2.5642	–2.64%	1.32%

B is incorrect. The appropriate risk-neutral strategy is to over-hedge (hedge ratio > 1) AUD and not hedge CHF.

C is incorrect. The appropriate risk-neutral strategy is to over-hedge (hedge ratio > 1) AUD and not hedge CHF.

Currency Management: An Introduction Learning Outcome

1. Describe how forward contracts and FX (foreign exchange) swaps are used to adjust hedge ratios

Is Campos most likely correct that Strategy 1 and Strategy 2 will accomplish the goals of exploiting market views and reducing hedging costs?

1. A.No, she is incorrect about reducing hedging costs.
2. B.No, she is incorrect about exploiting market views.
3. C.Yes.

In fact I tot Strategy 2 doesn't coz

Strategy 1 is put spread + write call; currency depreciates work

Strategy 2 is put spread + write call also, but currency appreciates. the puts part wrong... but...

Solution

B is correct. Campos suggests that both strategies help reduce hedging costs and allow the manager to exploit a market view. While it is true that both strategies help reduce hedging costs through premiums collected on short calls and puts, they both do not exploit the market view on the currencies, specifically, Strategy 1 does not.

Exhibit 3 indicates that the expectation is for the AUD to depreciate to BRL/AUD 2.0355 and for the CHF to appreciate to BRL/CHF 2.5642.

Strategy 1, the short seagull on the AUD, only provides downside protection to BRL/AUD 2.1006 (when the short put kicks in and neutralizes the hedge), not BRL/AUD 2.0355.

Under Strategy 2, the expectation is for an appreciation to BRL/CHF 2.5642; here the option premium is pocketed and because the option is written with a strike of BRL/CHF 2.5669, it will expire worthless if the rate never gets to BRL/CHF 2.5669

A is incorrect. It is true that both strategies help reduce hedging costs through premiums collected on short call and put.

C is incorrect. It is true that both strategies help reduce hedging costs through premiums collected on short call and put, but they both do not accommodate the market view on the currencies.

Currency Management: An Introduction Learning Outcome

1. Describe trading strategies used to reduce hedging costs and modify the risk–return characteristics of a foreign-currency portfolio

Marina Campos is a senior portfolio manager for Sabanai Investimentos in Sao Paulo, Brazil. Sabanai provides investment management and advisory services for high-net-worth and institutional clients. She is assisted by two portfolio analysts, Fabiana Traldi and Pedro Peixaria. Campos is meeting with Traldi and Peixaria to discuss the portfolios of three clients.

The first client is Gilvan Araujo Dias, a high-net-worth client who has given Sabanai responsibility for managing his foreign investments, which consist of equity investments in the United Kingdom and Germany. His other assets consist of equity and corporate bond investments in Brazil. Exhibit 1 summarizes information on Dias’s foreign portfolio holdings and exchange rates.

Exhibit 1

Gilvan Araujo Dias, Information on Foreign Asset Holdings and Exchange Rates

	UK Assets	German Assets	Spot Exchange Rates
Date	Value in GBP	Value in EUR	BRL/GBP	BRL/EUR
1/1/2013	83,400,000	55,000,000	3.8729	3.0359
1/1/2014	86,000,000	51,000,000	4.1025	3.5142

Based on the information provided in Exhibit 1, the domestic currency value of Dias’s foreign investments most likely:

1. A.decreased because of changes in the domestic currency value of foreign asset holdings.
2. B.increased because of changes in the domestic currency value of UK assets but decreased because of changes in the domestic currency value of German assets.
3. C.increased because of changes in the domestic currency value of foreign asset holdings.

GBP: 2.6/83.4 = 0.0312 = 3.12%

GBP currency: 3.8729 -> 4.1025 ; 5.93%

GBP total = 1.0312 * 1.0593 -1 = 9.235%

EUR: -4 / 55 = -7.27%

C: 3.0359 -> 3.5142; 0.4783 / 3.0359 = 15.755%

total EUR = 0.9273 * 1.15755 = 7.34%

Actually, your calculation is wrong becoz didn't consider weight

Solution

C is correct. The domestic currency value of Dias’s portfolio of foreign assets most likely increased because of changes in the domestic currency value of foreign asset holdings. The domestic currency return of the portfolio of foreign assets is:

RDC = w1(1 + RFC,GBP)(1 + RFX,GBP) + w2(1 + RFC,EUR)(1 + RFX,EUR) – 1

= 0.659(86,000,000/83,400,000)(4.1025/3.8729) + 0.341(51,000,000/55,000,000)(3.5142/3.0359)

= 0.659(1.0312)(1.0592) + 0.341(0.9273)(1.1575)

= 0.659(1.0923) + 0.341(1.0734)

= 0.0858

The calculations show that the domestic currency value of the portfolio of foreign assets increased because of changes (i.e., increases) in the domestic currency value of UK and German equity investments. Note:

w1 = 322,999,860/489,974,360 = 0.659

322999860 = 83.4mil * spot rate on 2013

166974500 = 55mil * 3.0359

both are initial weights

and

w2 = 166,974,500/489,974,360 = 0.341

A is incorrect. The domestic currency value of the portfolio increased, and the domestic currency value of UK and German investments increased.

B is incorrect. The domestic currency value of the portfolio increased because of increases in the domestic currency value of UK and German investments. It is the foreign currency value of German equity investments that declined.

Currency Management: An Introduction Learning Outcome

1. Analyze the effects of currency movements on portfolio risk and return