Reading 46: Currency Risk Management－LOS f 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 f: Discuss the use of options rather than futures/forwards to insure and hedge currency risk.

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Compared to options on currencies, futures contracts on currencies offer a:

A) less perfect hedge at a lower initial cost.

B) more perfect hedge at a lower initial cost.

C) less perfect hedge at a higher initial cost.

D) more perfect hedge at a higher initial cost.

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Answer and Explanation

Futures have a negligible initial cost and the symmetric payoff of the futures usually offers a more perfect hedge than that offered by a put contract, which has a premium that is an upfront cost.

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Jill Pope, CFA, is a portfolio manager in the United States that will begin managing a portfolio denominated only in Euros. Her supervisor asks her to hedge the portfolio against currency fluctuations using an instrument that will effectively be an insurance policy against downside risk while offering upside potential. To do this, Pope:

A) should sell put options on the $/
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Phil Johnson, CFA, is a portfolio manager in the United States and manages a portfolio denominated in yen. Johnson has been using forward contracts on the yen to hedge this portfolio, but now he is considering using put options. Johnson:

A) may choose to use put options if he wishes to more perfectly hedge his portfolio than was possible with the forward contracts.

B) may choose put options if he wishes to lower the upfront hedging costs from what he incurred using forward contracts.

C) should never use put options to hedge in this situation.

D) may choose to use put options if he wishes to allow for upside potential on currency changes while hedging downside risk.

---

Answer and Explanation

Put options offer the type of benefit described in the answer. They allow the upside potential of a yen appreciation, but there is a cost at the initiation of the hedge not incurred with forward and futures contracts.