38.g Explain the limitation to hedging the exchange rate risk of a foreign market portfolio and discuss two feasible strategies for managing such risk. Curious how you would answer it since schweser cant
Don’t know where I got this from, but I have it written in my notes 1) hedge both equity risk and currency risk 2) Estimate the ending value of your foreign portfolio then by currency forwards that have the same principal value as your ending value estimate. Thoughts??
Anyone else for a 2nd strategy?
it was in the errata. They forgot to put that in the books http://schweser.com/downloads/update_uploads/update_file_1766_LOS%2038.g_additional%20info.pdf
limitations 1) uncertainty of position To manage risk 1) hedge market exposure 2) use derivative contracts
- hedge foreign market exposure: expect foreign risk-free rate b4 currency conversion. 2. hedge both foreign market exposure and FX exposure: expect domestic risk-free rate.
limitation is that you can’t hedge 100% of foreign currency risk while remaining unhedged with respect to foreign market risk (b/c you don’t know the future value of the foreign market position). two options: 1. hedge local market risk only --> earn foreign RFR, subject to f/x risk 2. hedge local market risk and currency risk --> earns domestic RFR rand0m looks like we were typing the same thing at the same time…
Main limitation to hedging exchange rate risk is that you can only create a perfect hedge if you know the cash flows with certainty. This is only possible with foreign zero-coupon government bonds (and even then you have political risk). With anything else you. Two feasible strategies for managing such risk: I would have said 1) Hedge the principal 2) Make an estimate of principal+return and hedge that But mabye CSK’s answer is better.
Limitation: only hedges the principal Strategies: 1) Hedge principal and accept the exposure on the unhedged return. 2) Bypass the need for hedging currency by buying a futures on the position. If the future is available n your home country, then you have no currency risk. If you have to buy the future overseas, then only your margin is exposed to the currency risk.
to add to jimmylegs In order to hedge principal + return, the return has to be known and the only way for that to happen you have to lock the return (i.e., by hedging foeign market exposure). If you do that, you can only earn foreign Rf. After you do that, you can hedge the exchange rate risk, and if you do that then you can only earn domestic Rf. The whole reason for investing into foreign markets, is so you can earn excess returns, so Rf rate proposition doesn’t make whole lot of economic sence. That’s why in the long-run you will not use this strategy. However, in the short term, if you want to limit your exposure, without liquidating your position you can hedge foreign market risk and then fully hedge exchange rate risk.