Reading 46: Currency Risk Management－LOS c quantity, 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 c: Evaluate the effect of basis risk on the quantity of a currency hedge.

tycoon

In the hedging of currency risk, the issue of basis risk is:

A) a concern when using options and not futures contracts.

B) a concern when using forward contracts but not futures contracts.

C) not a concern when using either futures contracts or options.

D) a concern when using futures contracts and not options.

---

Answer and Explanation

Basis risk is the difference between the forward or futures price and the spot price. The variability of this measure is a source of risk in a futures or forward hedge where the maturity of the derivative is different from the horizon. Basis risk is not an issue in hedging with options.

tycoon

An analyst is managing a portfolio denominated in a foreign currency, and he plans to hold the portfolio one year. The analyst computes the hedge ratio of the portfolio to be equal to one, and he plans to implement the appropriate hedge. Which of the following actions will reduce basis risk?

A) Taking successive one-month futures contracts for the upcoming year.

B) Taking a futures position that matures in one year.

C) Taking a two-year futures position with plans of closing it in one year.

D) Nothing; since the hedge ratio equals one the basis risk is zero.

---

Answer and Explanation

An investor must be aware of basis risk anytime a futures hedge will be lifted prior to the futures maturity date. To avoid basis risk the investor would have to match the maturity of the futures contract with the intended holding period.