andytrader

A U.S. investor who holds a £2,000,000 investment wishes to hedge the portfolio against currency risk. The investor should:

A) sell £2,000,000 worth of futures for U.S. dollars.

B) buy £2,000,000 worth of futures for U.S. dollars.

C) sell $2,000,000 worth of futures for British pounds.

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The investor should sell £2,000,000 worth of futures contracts for U.S. dollars. This will offset the existing long position in pound-denominated assets. In so doing, the investor has effectively fixed the exchange rate for pounds into dollars for the duration of the futures contract.

andytrader

A basic strategy for hedging a portfolio against currency risk, where the investor hedges the foreign currency value of the foreign asset, is called:

A) cross-hedging.

B) hedging the basis.

C) hedging the principal.

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Cross-hedging is a strategy whereby a third currency is used to hedge a foreign currency exposure in a currency for which standard hedging vehicles are unavailable. Basis risk is the exposure to changes in the relationship between the forward price of an asset and its spot price. Hedging the principal is the basic strategy used by managers of foreign portfolios to minimize exposure to currency risk.

andytrader

The basic underlying goal of a currency hedge is to minimize a portfolio’s exposure to changes in:

A) exchange rates.

B) interest rates.

C) the basis.

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The management of currency risk is relevant for a portfolio with foreign investments. A currency hedge is utilized to minimize the negative effects caused by a change in the exchange rate between the domestic currency and the foreign currency.

andytrader

The manager of a single-currency portfolio is investigating methods to hedge the portfolio. If he regresses the return of the portfolio on the return of the currency, the:

A) slope coefficient of the regression represents the delta risk.

B) slope coefficient of the regression represents the economic risk.

C) intercept coefficient of the regression represents the economic risk.

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This is the measure of economic risk; it is the covariance of the portfolio return with the currency return over the variance of the currency return. Estimating this measure is part of composing a minimum-variance hedge.

andytrader

One issue addressed in a minimum-variance hedge over a hedge of the principal strategy is:

A) estimation risk.

B) the covariance of the local return (in the foreign market) and the exchange rate.

C) exchange rate risk.

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Both hedges address translation and exchange rate risk. Both hedges are subject to estimation risk. The minimum-variance hedge addresses the fact that the changes in the exchange rate can be correlated with the return in the foreign market.

andytrader

An analyst is exploring methods to hedge the return of a foreign asset in a foreign country as well as hedge the foreign exchange risk of the hedged amount. To implement a minimum-variance hedge over a hedge of the principal strategy a portfolio manager needs to set the hedge ratio for:

A) translation risk equal to one.

B) economic risk equal to one.

C) translation risk equal to zero.

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To implement a minimum-variance spread, the analyst should set the hedge ratio for translation risk equal to one and the hedge ratio for economic risk equal to the covariance of the local currency return with the currency return divided by the variance of the foreign currency.

andytrader

In managing the risk of a portfolio denominated in a foreign currency, which of the following is not a reason for using a minimum-variance hedge over a hedge of the principal strategy? A minimum variance hedge:

A) avoids having to perform a regression analysis with its associated statistical error.

B) uses the covariance of the return on the foreign assets and exchange rate covariance.

C) hedges against uncertainty concerning the return on the foreign assets.

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The purpose of the minimum-variance spread is to hedge the uncertainty of the return of the assets, which will make the final value different from the principal, and the translation risk associated with the exchange rate. The process does rely upon regression analysis and uses the covariance between the foreign assets and exchange rates.

andytrader

An analyst is managing a portfolio denominated in a foreign currency. In her analysis, she estimates that the hedge ratio of the portfolio is equal to one, and she implements the appropriate hedge. She also forecasts that there will be a negative correlation between the interest rate in her country and the interest rate associated with the foreign currency. This relationship of the interest rates:

A) will reduce but not eliminate the basis risk of the hedged position.

B) will introduce basis risk to the hedged position.

C) is unrelated to basis risk.

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Basis is the difference between the spot and futures exchange rates at a point in time. The magnitude of the basis depends upon the spot rate and the interest rate differential between the two economies. Interest rate parity describes the relationship between spot and futures exchange rates and local interest rates:
Hence, if the interest rates move in the opposite direction, then the basis will change.

andytrader

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

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

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

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

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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.

andytrader

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

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

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

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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.