2013 Mock Q52

It’s about UK investor who holds US and German portfolios. When discussing about hedging the ccy exposure, given investor is Short GBP, I always think that in the Fwd market they will enter into Sell USD / Buy GBP (if they think hedging is profitable) and Sell EUR / Buy GBP (also if profitable).

The answer is Sell EUR / Buy USD Fwd. Why do they enter into Buy USD in Fwd where they are currently Long USD portfolio? Thanks.

This is one of those questions where you just have to look at their expectations vs what they could lock in in the forward market. They forecast EUR/GBP to fall more than the forward market and the USD/GBP to rise more than the forward market, so they should trade accordingly and add to those positions.

I agree that this was a bit counterintuitive because they are actually adding to their current exposures instead of hedging them but on these types of questions always consider their forecasts.

The main purpose of hedging is not seeking profits but hedging risk, i.e., ccy risk. It is strange that he is long forward USD when he is holding USD currency. Either:

  1. his expctations are that USD is appreciating, even though that means he is doulbe betting here. This is not recommended under the CFA guidelines.

  2. there is a misunderstanding in the questions

In this particular example, the question is asking what would a manager do to ACTIVELY manage the ccy risk. He thinks that the dollar will appreciate more than what the interest rate differential implies… So he wants to take advantage of his opinion and buy more USD.