Reading 46: Currency Risk Management－LOS b interpret, currency, exchange

tycoon

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 b: Justify the use of a minimum-variance hedge when there is covariance between local currency returns and exchange rate movements and interpret the components of the minimum-variance hedge ratio in terms of translation risk and economic risk.

tycoon

In managing the risk of a portfolio denominated in a foreign currency, which of the following is not a reason for using a minimum-variance hedge over a hedge of the principal strategy? A minimum variance hedge:

A) avoids having to perform a regression analysis with its associated statistical error.

B) hedges against uncertainty concerning the return on the foreign assets.

C) hedges against exchange rate risk.

D) uses the covariance of the return on the foreign assets and exchange rate covariance.

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Answer and Explanation

The purpose of the minimum-variance spread is to hedge the uncertainty of the return of the assets, which will make the final value different from the principal, and the translation risk associated with the exchange rate. The process does rely upon regression analysis and uses the covariance between the foreign assets and exchange rates.

tycoon

An analyst is exploring methods to hedge the return of a foreign asset in a foreign country as well as hedge the foreign exchange risk of the hedged amount. To implement a minimum-variance hedge over a hedge of the principal strategy a portfolio manager needs to set the hedge ratio for:

A) economic risk equal to one.

B) translation risk equal to zero.

C) translation risk equal to one.

D) economic risk equal to zero.

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Answer and Explanation

To implement a minimum-variance spread, the analyst should set the hedge ratio for translation risk equal to one and the hedge ratio for economic risk equal to the covariance of the local currency return with the currency return divided by the variance of the foreign currency.

tycoon

One issue addressed in a minimum-variance hedge over a hedge of the principal strategy is:

A) estimation risk.

B) translation risk equal to zero.

C) exchange rate risk.

D) the covariance of the local return (in the foreign market) and the exchange rate.

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Answer and Explanation

Both hedges address translation and exchange rate risk. Both hedges are subject to estimation risk. The minimum-variance hedge addresses the fact that the changes in the exchange rate can be correlated with the return in the foreign market.

tycoon

The manager of a single-currency portfolio is investigating methods to hedge the portfolio. If he regresses the return of the portfolio on the return of the currency, the:

A) intercept coefficient of the regression represents the economic risk.

B) slope coefficient of the regression represents the delta risk.

C) slope coefficient of the regression represents the economic risk.

D) intercept coefficient of the regression represents the delta risk.

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Answer and Explanation

This is the measure of economic risk; it is the covariance of the portfolio return with the currency return over the variance of the currency return. Estimating this measure is part of composing a minimum-variance hedge.