Reading 46: Currency Risk Management－LOS g foreign, dynamic, standard, position, currency

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 g: Evaluate the effectiveness of a standard dynamic delta hedge strategy when hedging a foreign currency position.

tycoon

Phil Johnson, CFA, is a portfolio manager in the United States and has been using a delta hedge strategy using $/

tycoon

Phil Johnson, CFA, is a portfolio manager in the United States and has implemented a delta hedge strategy using put conracts on his ₤2,000,000 security portfolio. The delta is 0.667, and Johnson used this value in composing his delta hedge using put contracts. The value of the pound increases from $2.00/₤ to $2.10/₤. If the delta hedge works perfectly, then the change in the value of each put on each British pound will be closest to a/an:

A) decrease of $0.03.

B) increase of $0.07.

C) increase of $0.03.

D) decrease of $0.07.

---

Answer and Explanation

In dollar terms, the change in the exchange rate causes the value of the portfolio to increase by 5% or $200,000. Johnson would have purchased puts on ₤2,000,000. If the hedge is working perfectly, the put on each British pound would decline by approximatly $0.067, so $0.07 is the closest answer.

Delta = Change in option premium / Change in exchange rate

so delta x change in exchange rate = change in option premium

-.667 x $.10 = $-.07 

Delta = Change in option premium / Change in exchange rate

so delta x change in exchange rate = change in option premium

-.667 x $.10 = $-.07 

tycoon

Jill Pope, CFA, is a portfolio manager in the United States and has been using a delta hedge strategy using $/yen put conracts on her 10,000,000 yen security portfolio. The delta is 0.80. Other things equal, in dollar terms, a 0.100% decrease in the $/yen exchange rate would produce a:

A) 0.1% decrease in the security portfolio and a 0.125% increase in each put purchased.

B) 0.1% increase in the security portfolio and a 0.080% increase in each put purchased.

C) 0.1% decrease in the security portfolio and a 0.080% increase in each put purchased.

D) 0.1% increase in the security portfolio and a 0.125% decrease in each put purchased.

---

Answer and Explanation

The decrease in the $/yen exchange rate will lower the value of the portfolio in dollar terms because each yen will be able to be converted to fewer dollars. The delta of an option is defined as its value change relative to the value change of the underlying. Thus, the options will increase by 0.8 times the percent decline in the $/yen exchange rate.

tycoon

Bill Bender is a currency trader for International Investing Inc. Internationals portfolio managers specialize in finding attractive international investments for U.S. investors. Bender reviews these transactions and determines whether to hedge away some of the risk, then takes the appropriate hedging action.

Tonight he will speak to several hundred students taking investment classes at a local college, discussing strategies for hedging currency risk. While eating lunch, he prepares the following talking points:

• Options can be used to both directly and indirectly hedge currency risk. Futures can do the same.
• Direct hedging of the principal with futures allows investors to hedge away risk, but not to participate in any currency gains.
• A minimum-variance hedge is better than a simple hedge because it accounts for translation risk.
• To avoid basis risk, investors should make sure their futures contracts mature at the end of the asset holding period.

The analysts were busy this morning, and upon his return from lunch, Bender had a stack of proposed trades to review.

The first transaction involves a series of long and short equity trades on a variety of foreign markets. While the trades generally wash out market risk, they make no allowance for currency fluctuations. The profit margin on such strategies can be low, so Bender must keep costs to a minimum. Bender creates a strategy to hedge away much of the risk.

Another analyst wants to take long positions in a variety of European small-cap companies. While the analyst is confident that the stocks will deliver returns superior to other European small-caps, he is concerned that decreases in the euro will erode the returns for U.S. investors. The analyst has provided Bender with the following data:

• Portfolio value: