Reading 46: Currency Risk Management－LOS a investment, principal, currency

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 17: Portfolio Management in a Global Context
Reading 46: Currency Risk Management
LOS a: Demonstrate and explain the use of foreign exchange futures to hedge the currency exposure associated with the principal value of a foreign investment.

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The risk that the domestic currency returns to a foreign currency denominated portfolio will be negatively affected by changes in exchange rates is called:

A) basis risk.

B) currency risk.

C) economic risk.

D) translation risk.

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Answer and Explanation

Basis risk is the exposure to changes in the relationship between the forward price of an asset and its spot price. Economic risk occurs when the underlying foreign currency value of an investment changes. Translation risk occurs when the accounting value of a foreign asset is translated to the domestic currency. Currency risk, which includes both economic risk and translation risk, is the risk that the domestic currency returns to a foreign currency denominated portfolio will be negatively affected by changes in exchange rates.

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The basic underlying goal of a currency hedge is to minimize a portfolios exposure to changes in:

A) interest rates.

B) the basis.

C) intrinsic value.

D) exchange rates.

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Answer and Explanation

The management of currency risk is relevant for a portfolio with foreign investments. A currency hedge is utilized to minimize the negative effects caused by a change in the exchange rate between the domestic currency and the foreign currency.

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A basic strategy for hedging a portfolio against currency risk, where the investor hedges the foreign currency value of the foreign asset, is called:

A) hedging the basis.

B) cross-hedging.

C) hedging the principal.

D) multicurrency hedging.

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Answer and Explanation

Cross-hedging is a strategy whereby a third currency is used to hedge a foreign currency exposure in a currency for which standard hedging vehicles are unavailable. Basis risk is the exposure to changes in the relationship between the forward price of an asset and its spot price. Hedging the principal is the basic strategy used by managers of foreign portfolios to minimize exposure to currency risk.

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A U.S. investor who holds a £2,000,000 investment wishes to hedge the portfolio against currency risk. The investor should:

A) buy futures for £2,000,000 worth of U.S. dollars.

B) sell futures for $2,000,000 worth of British pounds.

C) sell futures for £2,000,000 worth of U.S. dollars.

D) buy futures for $2,000,000 worth of British pounds.

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Answer and Explanation

The investor should sell futures contracts with a value of £2,000,000 vs. U.S. dollars. This will offset the existing long position in pound-denominated assets. In so doing, the investor has effectively fixed the exchange rate for pounds into dollars for the duration of the futures contract.

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Which of the following equations represents the net profit/loss on a hedged position, in domestic currency terms?

A) ( Vt St - V0 S0) (V0 (-Ft + F0)).

B) (Vt* - V0*) / V0*.

C) Vt St - V0 S0.

D) V0 (-Ft + F0).

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Answer and Explanation

Recall the following variables used in hedge analysis:

V₀ The value of the portfolio of foreign assets at time 0, stated in the foreign currency.

V_t The value of the portfolio of foreign assets at time t, stated in the foreign currency.

V_t* - The value of the portfolio of foreign assets at time t, stated in the domestic currency.

S_t The spot rate, quoted at time t.

F_t The futures exchange rate, quoted at time t.

(V_t* - V₀*) / V₀* is the portfolio rate of return, stated in domestic currency terms. V_t S_t - V₀ S₀ is the gain or loss on a portfolio, stated in domestic currency terms. V₀ (-F_t + F₀) is the gain or loss on a futures position, stated in domestic currency terms. Therefore, the net profit/loss, in domestic currency, is equal to (V_t S_t - V₀ S₀) (V₀ (-F_t + F₀)).

Recall the following variables used in hedge analysis:

V₀ The value of the portfolio of foreign assets at time 0, stated in the foreign currency.

V_t The value of the portfolio of foreign assets at time t, stated in the foreign currency.

V_t* - The value of the portfolio of foreign assets at time t, stated in the domestic currency.

S_t The spot rate, quoted at time t.

F_t The futures exchange rate, quoted at time t.

(V_t* - V₀*) / V₀* is the portfolio rate of return, stated in domestic currency terms. V_t S_t - V₀ S₀ is the gain or loss on a portfolio, stated in domestic currency terms. V₀ (-F_t + F₀) is the gain or loss on a futures position, stated in domestic currency terms. Therefore, the net profit/loss, in domestic currency, is equal to (V_t S_t - V₀ S₀) (V₀ (-F_t + F₀)).

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The manager of a large, multi-currency portfolio is investigating methods to hedge the portfolio. If she regresses the return of the portfolio on several major currencies, she is most likely trying to solve the problem of:

A) the symmetry of the payoff of forward and futures contracts.

B) the asymmetry of the payoff of forward and futures contracts.

C) the overpricing associated with those particular currencies.

D) illiquid forward and futures markets for some currencies.

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Answer and Explanation

The managers regression would most likely be part of setting up a cross-hedge, which is to remedy the problem that some of the currencies represented in the portfolio will probably have illiquid forward and futures markets.