If a manager plans to use currency forwards to hedge a long position in foreign equities, then which of the following would be a reasonable strategy? A) Short an amount that is more than the current equity position. B) Go long an amount that is more than the current equity position. C) Go long an amount that is less than the current equity position. D) Short an amount that is less than the current equity position. Your answer: A was incorrect. The correct answer was D) Short an amount that is less than the current equity position. The manager would want to short the forward contracts to hedge depreciation of the foreign currency. The manager would want to hedge an amount less than the equity position because that position may decline in value from the equity risk. This is schweser provided answer. I picked A because what if the equity position value increase? What am I missing? Or Schweser is full of it on this question? Thanks
you have returns on two levels, the security returns and the currency returns. worse case scenario over the long term, foreign currency risk/losses goes to zero (because of diversification). in the best case, you made some currency returns, (foreign currency appreciated). therefore don’t need to short an identical amount of contracts, short fewer and use the currency appreciation to offset the fewer amount of contracts (you shorted) and therefore losses that may occur. almo.
It sounds like that we are less concerned with building a “perfect” hedge, rather we are more concerned with downside (currency depreciation and equity depreciation) risk, am I correct? Thanks.
ws Wrote: ------------------------------------------------------- > It sounds like that we are less concerned with > building a “perfect” hedge, rather we are more > concerned with downside (currency depreciation and > equity depreciation) risk, am I correct? > > Thanks. I chose D for the same reason - protect downside (currency depreciation).
based on minimum-variance hedge ratio (= 1 + cov(R[local], FX) / var[FX]), if security return is negatively correlated with currency return, then under hedge; if security return is positively correlated with currency return, then over hedge. wouldn’t schweser want us to relate this to LOS 46 (b) ?
I’m with random here - depends on the correlation. It’s even possible to get market based estimates of the correlation from quanto derivatives. For example, the CME has a Nikkei contract which pays off $5 * Nikkei value (something denominated in a foreign currency that pays off in dollar terms like this is called quanto). If you get option prices on yen, unquanto Nikkei, and quanto Nikkei you can get a market-based estimate of yen-Nikkei expected correlation.
rand0m Wrote: ------------------------------------------------------- > based on minimum-variance hedge ratio (= 1 + > cov(R, FX) / var), > > if security return is negatively correlated with > currency return, then under hedge; > if security return is positively correlated with > currency return, then over hedge. > > wouldn’t schweser want us to relate this to LOS 46 > (b) ? Thanks, that makes perfect sense!!!
Isnt’ security return usually positively correlated with currency return? Because, Strong economy->rising equity price Strong economy->strong currency rand0m Wrote: ------------------------------------------------------- > based on minimum-variance hedge ratio (= 1 + > cov(R, FX) / var), > > if security return is negatively correlated with > currency return, then under hedge; > if security return is positively correlated with > currency return, then over hedge. > > wouldn’t schweser want us to relate this to LOS 46 > (b) ?
not necessary, what if the economy is export driven …
Who said strong economy, strong currency? What does IRP say about that? I.e., there is no demand for money so interest rates are at 1% while elsewhere there is a 5% interest rate. From 1989 through 1995 or something the Nikkei lost 2/3 of its value and the yen appreciated versus the dollar (while the S&P was enjoying a nice run up).
What about US dollar now? We have both weak economy and weak currency, while Asian economies are stronger now, and their currencies are stronger as well. I think IRP suggests the direction of a longer term currency movement while in a short term, the relative strength of economy determines the currency movement. With that said, I think the correlation between currency and equity returns is not just simply positive or negative. So I think an appropriate explanation to the Schweser’s question is the manager wants to get protection from downside risk.
Currency &(vs) equity return, that is the egg and chicken in finance.
^ yep and a complicated dance. "I think IRP suggests the direction of a longer term currency " To the extent that IRP is covered interest rate arb it is a very strong effect.