Derivatives question from CFA Soc Boston 2021 Practice Exam (afternoon, question 24)

Afternoon exam, question 24 on hedging currency exposure:

  • U.S. based firm acquiring a firm in the U.K. with GBP 400mm in holdings
  • U.S. vol = 4.6% // GBP Vol = 2.5%
  • Corr = 0.25

Question from practice exam: ‘Using the information in Exhibit 1, which position would best implement Bluerock’s min-var hedge against Concord Associates’ exposure?’

Formula: hedge = corr * (vol DC / vol FC)
=0.25 * (4.6% / 2.5%) = 0.46

Notional of GBP 400mm so we get:

Hedge position = 0.46 * GBP 400mm = GBP 184 million

Answer options:

A - short a GBP / USD forward contract with a notional size of GBP 184mm
B - long a USD / GBP forward contract with a notional size of USD 184mm
C - long a GBP / USD forward contract with a notional size of GBP 184mm

Answer explanation in answer key (after giving you hedge amount):

"Bluerock will have a holding of GBP 400 million after the acquisition. Bluerock should short the GBP in a forward contract to hedge the risk of exchange rate fluctuations.

Hence, Bluerock should be long GBP / USD."

I’m going crazy here! The second to last sentence seems to imply answer A, while the very last sentence (and the correct one, per the answer key) implies answer C. What am I missing? Is this just an error? That second to last sentence is repeated almost word for word in answer A!

Thanks if you can set me straight!

Because ur taking a position in GBP and you want to hedge this position, you need to take an opposite position in the forward contract. Therefore, you need to short GBP forward. However u need to pay attention to the way the currency is denoted. If you want to short the GBP forward then it would need to have GBP as the base currency. I.e short USD/GBP is equivalent to long GBP/USD. Hope this helps

You rock, thanks for this clarification!

really? i think the solution is wrong.

from vignette, pUSD/GBP=0.25

from solution, pGBP/USD=0.25

oh you are right, the denominator is the price currency.