Reading 46: Currency Risk Management－LOS h investment, substitute, including

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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 h: Discuss and justify other methods of managing currency exposure, including the indirect currency hedge created when futures or options are used as a substitute for the underlying investment.

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Jill Pope, CFA, has been managing a stock portfolio denominated in a foreign currency and has set a particular nominal return goal for the portfolio. She wishes to investigate ways to achieve the goal while lowering the currency risk. Which of the following strategies is most appropriate?

A) Increasing the duration of the stock portfolio.

B) Decreasing the beta of the stock portfolio.

C) Decreasing the duration of the stock portfolio.

D) Increasing the beta of the stock portfolio.

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Answer and Explanation

By increasing beta, Pope has increased the risk exposure to the local market factors relative to the currency exposure. Pope will be able to achieve a given return objective with less currency risk. Since it is a stock portfolio, duration is not relevant.

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When adding exposure to equities in a foreign market to your portfolio, which of the following strategies would offer the lowest amount of currency risk? In:

A) the foreign futures market going short index futures on an index on the foreign market.

B) your domestic futures market going long index futures on an index on the foreign market.

C) your domestic futures market going long index futures on an index on your domestic foreign market.

D) the foreign futures market going short index futures on an index on your domestic market.

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Answer and Explanation

You would want to go long futures on the foreign index. You can choose to go long foreign equity index futures and would only have the initial margin committed (i.e., exposed to translation risk). Further, you may find the desired index future traded on a domestic exchange. In that case, currency exposure is totally eliminated, because prices (including margins) are stated in your domestic currency.

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When adding exposure to equities in a foreign market to your portfolio, which of the following strategies would offer the lowest amount of currency risk? In:

A) your domestic derivatives market going long call options on an index on the foreign market.

B) the foreign derivatives market going short call options on an index on the foreign market.

C) your domestic derivatives market going long call options on an index on your domestic market.

D) the foreign derivatives market going short call options on an index on your domestic market.

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Answer and Explanation

You would want to go long call options on the foreign index. You can choose to purchase calls on the index and would only have the initial premium committed (i.e., exposed to translation risk). Further, you may find the desired call options traded on your domestic exchange. In this case, translation risk is totally eliminated, because the premiums are stated in your domestic currency.