Reading 38: Risk Management App....ures Strategies－LOS g exchange, market, foreign, discuss, managing

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CFA Institute Area 8-11, 13: Asset Valuation
Session 13: Risk Management Applications of Derivatives
Reading 38: Risk Management Applications of Forward and Futures Strategies
LOS g: Explain the limitations to hedging the exchange rate risk of a foreign market portfolio and discuss two feasible strategies for managing such risk.

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When hedging the exchange-rate risk of a foreign currency-denominated equity portfolio, a manager must recognize that the position has:

A) both equity risk and foreign exchange risk.

B) equity risk only.

C) exchange-rate risk only.

D) economic risk only.

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Answer and Explanation

The position will have both equity and foreign exchange risk. This makes the position, in isolation, more risky than a domestic equity portfolio.

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An asset manager says he has perfectly hedged an equity portfolio that is denominated in a foreign currency by only using forward currency contracts. We know then that the:

A) asset manager is not telling the truth.

B) number of contracts used is greater than that used on a comparable equity position.

C) number of contracts used is less than that used on a comparable equity position.

D) number of contracts used is equal to that used on a comparable equity position.

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Answer and Explanation

Since the asset manager cannot know the future value of the equity position, it is impossible to perfectly hedge the position with only currency contracts.

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All else being equal, when investing in foreign equity assets, the exchange-rate dimension of the investment generally:

A) increases the total risk.

B) diversifies the position and thus lowers risk.

C) is unrelated to total risk.

D) can be completely hedged.

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Answer and Explanation

Holding all else equal, the exchange-rate dimension generally adds risk. If we were to drop the all else being equal assumption, then we could make the case that the diversification were risk-reducing. This risk cannot be completely hedged with currency forward contracts alone.

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In order to perfectly hedge an investment in foreign equities, a manager would most likely have to use:

A) both currency forwards and equity futures.

B) both currency futures and equity forwards.

C) currency forwards only.

D) equity futures only.

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Answer and Explanation

Forwards are most often used for currency risk and futures are most often used for equity risk. The manager would have to use both contracts to completely hedge all the risk.

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If a manger shorts a forward currency contract to hedge the expected value of a foreign-equity portfolio in one year. The worst-case scenario is if the portfolios return is:

A) greater than the expected value and the currency appreciates.

B) less than the expected value and the currency depreciates.

C) greater than the expected value and the currency depreciates.

D) less than the expected value and the currency appreciates.

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Answer and Explanation

This should be obvious because a decline in the equity position is bad and the short position in a forward currency contract hurts when the foreign currency appreciates. If the equity position falls short of the contracted amount, in addition to the loss from the decline in asset prices, then the manager will suffer a loss equal to the difference in the hedged amount and the actual equity value times the difference in the spot and contracted forward rate.

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If a manager plans to use currency forwards to hedge a long position in foreign equities, then which of the following would be a reasonable strategy?

A) Short an amount that is more than the current equity position.

B) Short an amount that is less than the current equity position.

C) Go long an amount that is more than the current equity position.

D) Go long an amount that is less than the current equity position.

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Answer and Explanation

The manager would want to short the forward contracts to hedge depreciation of the foreign currency. The manager would want to hedge an amount less than the equity position because that position may decline in value from the equity risk.