Reading 46: Currency Risk Management－LOS e issues, multiple

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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 e: Explain the issues that arise when hedging multiple currencies.

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Jill Pope, CFA, manages a large multinational portfolio that includes assets denominated in over 20 currencies. Pope is planning to hedge this portfolio for currency risk. Composing:

A) a perfect hedge is always possible because all currencies have futures markets that can compose hedges for each currency.

B) a perfect hedge may not be possible, but she may be able to compose an effective hedge with futures on a few major currencies.

C) a hedge with any measurable effectiveness is not possible because of the many currencies.

D) a perfect hedge with a single futures contract on major currencies is generally possible.

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Answer and Explanation

Since many currencies do not have actively traded futures markets, the best choice for hedging a portfolio like the one in this problem would be to choose a few contracts on major currencies. To determine the best type and number of contracts, Pope can use a multiple regression of the returns of her portfolio on the futures returns of liquid contracts for a few major currencies.

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One of the problems in hedging the currency risk of a portfolio that has assets in many currencies is:

A) the negative correlation of each major currency with the value of its corresponding asset.

B) some of the currencies in which assets are denominated may not have liquid contracts that can provide adequate hedges.

C) that they are inherently unhedgable.

D) nothing; they can be hedged like any single currency portfolio.

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Answer and Explanation

Currency futures and forward contracts are not always actively traded, so hedging the movements in some of the currencies in a multicurrency portfolio may be difficult and inefficient. In these cases it may be desirable to use a cross hedge (i.e., hedge using an actively-traded futures contract on a correlated currency).

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In managing international, multi-currency portfolios, cross-hedging:

A) is not a technique used in this case.

B) refers to hedging a stock with a bond, but both are denominated in the same currency.

C) refers to hedging a bond with a stock, but both are denominated in the same currency.

D) refers to using the forward contracts on one currency to hedge the currency risk of another currency.

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Answer and Explanation

Currency futures and forward contracts are not always actively traded, so hedging the movements in some of the currencies in a multicurrency portfolio may be difficult and inefficient. In these cases it may be desirable to use a cross hedge (i.e., hedge using an actively-traded futures contract on a correlated currency).