Application of Derivatives - Wintermantle

Using a three-month futures contract on the Nikkei 225 Index that is currently valued at JPY8,935,000…Cai agrees with Wintermantle but expresses concern about unfavorable moves in the value of the Japanese yen. He asks whether it would be possible to completely hedge foreign currency risk. Wintermantle responds that in order to fully hedge yen currency risk, he would need to hedge foreign equity market exposure as well as the currency exposure.

How would he hedge equity exposure to fully hedge its currency risk, if the equity exposure was done through longing a JPN Gov bond and the index future?

I believe that Wintermantle’s wrong on that point.

Not sure really what you’re asking, but he’d need to know the ending value of the index to be able to determine how much currency exposure to hedge.

True, but if you’re already long the index with futures, then how are you going to fully hedge the currency risk?

Is Wintermantle’s response to Cai’s question about fully hedging Japanese yen currency risk most likely correct

A) No, he is incorrect about hedging currency risk

B) Yes

C) No, he is incorrect about hedging foreign equity market exposure

Correct answer is B)

To fully hedge currency risk, both the foreign equity market exposure and the currency risk must be hedged. Cai is long the Nikkei and the JPY. To completely hedge currency exposure, Cai would need to know how much JPY to deliver in the future, but this amount is unknown and dependent on the Nikkei’s future value. The only way to know this amount now would be to hedge exposure to the Nikkei by using Nikkei futures to lock in the amount of JPY to be delivered in the future.

S2000 BAND 10!!

It makes sense to me

Yeah so I guess it’s all hypothetical. Seem’s like a pointless concept though - can’t actually do it.

Follow up on Wintermantle case:

A pension plan would like to use futures to gain exposure to an asset class in advance of the cash receipt from the plan sponsor, which comments are correct?

A: “In this case, it is possible to gain exposure to an asset class by taking long positions in risk free bonds and futures on the asset class.”

B: “A long position in futures on the asset class is sufficient to gain exposure to the underlying asset. Specifically, it is equivalent to borrowing against cash to be received in the future and investing in the underlying asset.”

Aren’t both A and B are correct?

A correct.

B not sure but looks not correct.

The correct answer is B. Answer A is wrong !

explain, please!

I agree with you A should also be correct. Long underlying + short futures= long risk free, so long underlying= long risk free+long futures.

The CFA explanation for answer B is :

“Futures contracts can be used to gain exposure to an asset class in advance of a cash receipt. This is called pre-investing in an asset class. A long position in a futures contract is equivalent to being long the underlying plus a loan. That is, it is a fully leveraged position on the underlying asset.”