Currency hedge

  1. solution to #Hedge 2 on page 253 CFAI vol 5. The case is as under

HKD reporting currency.forward for hedge coming up for settlement. FX swap to be used to roll over

Hedge: short position of Eur 8000000 due on HKD/EUR forward. mkt value of EUR has increased. HKD/ EUR expected to depreciate

Currency Spot 3 mnth frwrd pts

HKD/EUR 10.0200 - 0210 125/135 (scaled by 10000)

mismatch swap …,. but Euro spot @ 102…Why? and sell frwd more than Eur 8000000 @10.02 + 125/10000 = 10.0325. did nt understand the spot part. It says one should use the BID side for both the spot and forward points

Original Hedge was Sell 800,000 EUR.

Now at rollover time. … you need to buy 800,000 EUR at the Spot Price. (This offsets the original Forward contract).

This rolls over the hedge: and then sell More than 800000 EUR Forward. (The More than is because the Market value of the underlying has increased).

Since you are Selling the EUR forward - you need the bid side of the quote, bid side of the points.

yes understood the futures part. the solution says use bid side for buying Euro at spot price. why?

you buy at the bid, sell at the ask.

once you have the foreign currency as the “Base” (which it is in the case above since it is a HKD/EUR - EUR is the base price) - you have to now buy the BASE - at the BID.

As i understand,in a bid -offer quote given by a dealer, you as client, hit the bid if you want to sell and vice versa. confused here. anyway thanks. will revisit the material.


Confused2010, I’ve the same issue.

I don’t understand why we should buy spot at the bid rate (but I understand why we should sell forward at the bid rate). I think there is a mistake but I’ve found nothing on the material errata uploaded by the CFA Institute on their website.

@cpk123, I think the DEALER buy the base @bid and so the client sell the base @bid (client sell low and buy high).

Please accept my apologies for my english, it’s the first time I post something in english on a forumboard :slight_smile:

ok since i was short the base at intiation, i’d long the spot base at bid to deliver on expiry and i short the forward base at ask to rollover.

why am i buying the (forward) base at the bid then?

This entire section has me confused. What is the significance of the base currency? I read somewhere that it is second of the two currencies and that it is the reporting currency. In this particular question HKD is the reporting currency yet in hedge 2, EUR is the base currency. Obviously I have misunderstood this concept.

In hedge 2 the individual has a short position of EUR 8M. If the spot rate is expected to deteriorate then my understanding if it is correct is that it will take more HKD to buy 1 EUR or less EUR to buy 1HKD. So if you are short EUR 8M you buy EUR Euro 8M by selling HKD which now cost more. I therefore cannot understand how this allows Yang to take advantage of depreciation. I also not sure which side of the rate to use. If I accept that I am selling HKD then the lower rate is applicable.

I probably have this wrong and any clarification would be appreciated.

I had the same confusion on this swap month ago. Here is what I understand:

As manager wants to roll over the short position on EUR more than original hedge, he enters the FX swap by buying at spot on nominal value of EUR 8M and selling at forward on nominal value more than 8M. Here is catch: The mismatched size adjustment should be reflected in the pricing. In this example, a net sell of EUR (think of the mismatch swap as a matched swap plus the net amount, here is the net sell of EUR). Since a matched swap has already priced forward points on the bid side, the mismatched adjustment will be reflected in the spot rate. As a net amount of EUR is being short, the spot quote will now be on the BID side for adjusting the mismatch of the size for pricing the swap.

Besides, a swap will have a market value of zero at initiation (Derivative is priced arbitrage free). Therefore, the two legs of the swap should use the same spot rate (bid or ask) to keep arbitrage free and leave the forward points for risk reward.

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Thanks so much!
Your explanation makes sense.
I totally agree with you.