Testa takes position in a New Zealand firm and an Australian firm, and wants to minimize foreign exchange exposure.
direct hedge on each currency separately
cross-hedge of the two currencies in the portfolio
minimum-variance hedge of the two currencies in the portfolio.
Answer is A. Answer key says: “The high correlation between the currencies could have been exploited with a cross-hedge or a minimum-variance hedge if one of the foreign assets was held long and the short”.
I don’t understand what it means. I thought “cross-hedge of the two currencies” means cross hedge New Zealand currency and AUD with another currency, “MV hedge of the two currencies” means hedge two currencies separately using MV hedging method.
I guess the question was trying to say hedge the two currencies against each other?
Testa is long AUD and long NZD. I don’t know what Testa’s home currency is, but, for the sake of discussion, let’s assume that it’s CAD. (If you tell me what it is, and it’s not CAD, I’ll do a search-and-replace of CAD with whatever it is.) In both of these investments, Testa is short CAD.
A cross-hedge for AUD would use a currency pair comprising AUD and a currency with a strong (price) correlation with CAD, such as USD. So Testa would hedge with AUD/USD futures or forwards or options. Note that Testa is long AUD and short CAD, and is hedging that position.
A cross-hedge for NZD would use a currency pair comprising NZD and a currency with a strong (price) correlation with CAD, such as USD. So Testa would hedge with NZD/USD futures or forwards or options. Note that Testa is long NZD and short CAD, and is hedging that position.
Testa cannot hedge the exposure to AUD and NZD with a cross-hedge because Testa is neither long-AUD-and-short-NZD nor long-NZD-and-short-AUD.
A minimum-variance hedge behaves similarly to the cross-hedge: Testa is hedging a long-in-one-currency-and-short-in-another-currency position.