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) Short an amount that is less than the current equity position. C) Go long an amount that is more than the current equity position.
A
that’s what I thought. But here is Schweser’s answer: Your answer: A was incorrect. The correct answer was B) 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. it doesn’t make sense to me becuase if you anticipate a decline in equity market and a depreciation of the currency, why not just sell the foreign equity??
A ?
A?
The answer does not make sense. They have to state in the q that they expect the currency to depreciate. They did not say anything.
Though not Schweser’s best question or explanation, B is the only one that seems logical. Forget the currency dpn…investors never hedge more than the principal/current value of the portfolio. If you hedge more than the current principal/CV…you are currency speculating.
BlueCollarHero’s explanation makes sense.
B to save an investor from double whammy of foreign equity value going down and foreign currency appreciating…
If you think the currency is going to depreciate, why wouldn’t you just hedge the principle instead of an amount lower than that? What’s the logic behind that? Or is it that its just in this case that we choose B because that is the best choice?
sparty419: what you have mentioned is a good strategy when principle amount in foreign currency is known with certainty on the date forward contract is entered. But how to know that when one books forward contract? For equity if value goes down on the date of forward expiry, the position can be very risky (losses on currency and equity both). Rather, a solution could be first to hedge foreign returns and then hedge in local currency terms
Hi rp77, thanks for that. But unfortunately my brain isnt fully functional today, so I am going to see if I can provide a practical example. So, if I am managing $1,000 worth of foreign equity and I know 1 month down the foreign currency is going to depreciate, then I would try and go short on $1,000 on the current rate or the favorable forward rate. So, regardless of the equity value falling, I have profited from going short on my principle right? If the equity value increase, well, I lose, tough luck. I don’t know if that made sense, but I hope u get where I am coming from.
According to the CFAI material, I recall reading a passage that indicated that foreign equity is partially hedged internally. After all, if the currency depreciates, then the foreign company should presumably be more competitive and earnings should go up leading to presumably higher stock prices… Thus the need to hedge is reduced.
tomsimons Wrote: ------------------------------------------------------- > According to the CFAI material, I recall reading a > passage that indicated that foreign equity is > partially hedged internally. After all, if the > currency depreciates, then the foreign company > should presumably be more competitive and earnings > should go up leading to presumably higher stock > prices… Thus the need to hedge is reduced. Sounds plausible. But what if the company’s sole business was importing goods from overseas for resale in the domestic country? It would have a negative relationship with the exchange rate.
I agree its faulty… for instance what of the case of a manufacturing company that becomes permanently less competitive due to currency appreciation? Sometimes it helps to suspend your critical thoughts on what they say and just go with it lol. I don’t agree with it, but I know that’s what they say.