2011 Morning Session #8c - Am I going crazy?

CFA Level III
#1

I’m obviously missing something really simple here:

The problem statement says that the “principal value of the portfolio is currency hedged using a three-month forward contract”. So If they sell forward at the rate of .87PLN = 1LHS, why in the answer key do they have them converting back to PLN at the Spot rate of .80? Shouldn’t they get to convert the principal back at .87?

Like I said, I’m obviously missing something really simple here, it’s 10:00PM on Friday night and I’ve been working since 7:30 AM, maybe time to call it a night. . . . .

If someone can help me out here, I’d be glad to help them on a ridiculous question they have. . . . (after some rest of course. . )

#2

[Bond /Equity] Profit/Loss =Vt*St-V0*S0

[Short Forward] Profit/Loss =Exposure*[F-St]=35000000*[0.87-0.8]=2450000

i suppose the answer given is inaccurate since the value of a forward contract is zero at inception anyways…so when the answer says ‘Initial value of fwd is xxx’ …it is wrong by defintion…i may be wrong here…but it seems a bit sloppy.

oh and fyi …yes you are going crazy…welcome to a place i call home.

#3

This seems to be an anamoly.

They have not considered the principal hedging at forward rate. No apparent reason as of now.

#4

not sure if I am understanding what is being said.

Portfolio Original Value = 35 Mill LHS = 35 * 0.87 = 30.45 PLN

Final:

Bonds = 25 * 1.1 * 0.80 = 22 Mill PLN

Equities = 10 *.8 * .8 = 6.4 Mill PLN

Forwards = - 35 ( 0.8 - 0.87 ) = +2.45 Mill PLN

End Value Portfolio = 22 + 6.4 + 2.45 = 30.85 Mill PLN

Gain = 0.40 Mill PLN

Seems to be perfectly fine.

Where is the discrepancy, please point it out to me again???

#5

cpk, i think you have cleared the doubt. I do not have access to ques right now though. Let me read it again once i can .

I think by separating account (i.e investment in foreign asset & investment in currency futures) you are bang on target.

It reminded SCH words for the exams relating to these type of question: do not try shortcuts. That is calculate the unhedged return (i.e. at spot rate at the time of entering the position & current spot rate) & calculate the return on futures contract to arrive at the total return.

#6

I used the “Stalla” method and came up with gain of $460K, not sure if they gave me full credit or not…

Stalla way:

unhedged = (1+LCR)(1+LMR) -1 = -6.73%

hedged = unhedged from above - (F1 - F0 / S0) = -6.73% - (-8.055) = +1.32%

1.32% * 35M = gain of 460K

anyone else do it this way?

#7

How did you arrive at those numbers?

What did you consider the market? ( because Bonds and Stocks movements are different )

#8

market return:

bonds beg value = 25, end value = 25(1.10) = 27.5

equity beg value = 10, end value = 10(.80) = 8

end total value = 35.5

beg total value = 35

gain = 35.5 / 35 -1 = 1.43% for local market return

local currency return = s1 / s0 -1 = .80 / .87 - 1 = -8.05%

so, unhedged return = (1+LCR)(1+LCM) - 1 = (-.9195)(1.0143)-1 = -6.73%

thus, hedged return = -6.73 - (f1 - f0 / s0) = -6.73 - ( -.0805) = gain of +1.32%

#9

This might work for an entire portfolio that moves in a parallel manner.

for the individual components - bonds and stocks that move differently… it is not entirely evident from the text whether this method is applicable. That is all I can think of.

and I am also not sure if they will give credit for this approach. They might give partial credit, but not sure at all.

#10

cpk you know everything!..how does the partial credit grading system work?

#11
  • For an question like this, studying Notes/Books has little help.
  • Quickly creating a Table and filling it with a calculated data is the key.
  • Bullet, Equation and Table are three popuar structures in standard answers.
#12

So would my post (post 2 above) be ok?

#13

i dont think you’d get more than 2 points (out of 5) for the second post - you didnt calcualte the final gain/loss for the portfolio, only the forward

#14

yup

#15

CPK,

Thank you! This is going to sound ridiculous, but after glancing at your answer, I realized my problem was “not reading the question statement.” I glazed over the table with the securities and the market value assuming the final row was simply a portfolio total without reading its description "Notional value. . . " . I’m actually glad this came up though, especially as I work through CFAI’s solutions to these past morning sessions because it is a great example of the difference between how Schweser and CFAI present solutions and problem solving methods. The method you demonstrated is exactly how Schweser works through these hedging problems; treat the underlying positions separate from the hedge. This is how i prefer to logicly solve the problem as well. CFAI’s solution gets you the same answer, but in a very unintuitive way.

I owe you one. Got any ridiculous questions I can dive into?