Exchange rate risk Question

What would your ansa be? and why? If a manager shorts a forward currency contract to hedge the expected value of a foreign-equity portfolio in one year. The worst-case scenario is if the portfolio’s return is: A) less than the expected value and the currency appreciates. B) less than the expected value and the currency depreciates. C) greater than the expected value and the currency appreciates.



a - “less than expected value” because the PF value is not hedged, only the currency exposure, and “currency appreciates” because it diminishes the value of the currency contract

you are hedging the expected value of your portfolio. thus if you think that value will be more in the fuutre you will hedge more notional today. so you will short more. now if the portfolio rises less than expected you will have hedged too much. further if the currecny appreciates and your short you will get hit on the short position also. PS> i have been dead wrong in the past

I would go with A. I assume that the local currency (where the investment is made) is the one that appreciates relative to the domestic currency (investor’s home country). As the currency appreciates the investor realizes a loss on the futures contract which is more than the gain in the underlying because the return on the underlying is less than expected.

magix, you are making sence. great explanation.



A Worse case scenarios : The foreign currency appreciates. Loss on the futures contract Worse case scenarios : The portfolio value is less than expected

A – portfolio appreciates less than expected so you have to buy foreign currency at expiration to fulfill the contract (the portfolio doesn’t cover the FC value of the contract), which is now more expensive.

gotta say B. with a foreign equity portfolio you want 2 things: the foreign currency to appreciate and the equity to increase. B does neither.

A. you shorted the contract so you agreed to Sell @ Ft. But at contract expiration, spot has appreciated more than Ft, hence you lose out on that side of the transaciton.

ahh, I cahnge my answer to A. didn;t see the “Shorting the contract” in there

OMG I stand all alone in this crowd … my choice would be C My thinking is there will be a loss when currency appreciates as he has locked in a short position and the loss will increase in magnitude as the expected return on the portfolio increases.

heer, think of them as two unique parts… you want the portfolio to increase & the currency to appreciate (assuming you didn’t short contracts)…


Hi Guys, thanks for all your responses. I was a little confused myself hence I thought I´d ask the forum. The correct answer was A. A decline in the equity position is bad and the short position in a forward currency contract hurts when the foreign currency appreciates. If the equity position falls short of the contracted amount, in addition to the loss from the decline in asset prices, then the manager will suffer a loss equal to the difference in the hedged amount and the actual equity value times the difference in the spot and contracted forward rate.

3rd & Long Wrote: ------------------------------------------------------- > heer, think of them as two unique parts… you > want the portfolio to increase & the currency to > appreciate (assuming you didn’t short contracts)… now I have to agree they need to be looked at as unique parts

on the FC asset side - worst case is if the asset is worth less than expected on the FC currency side - you sold the FC Fwd because you thought the FC would depreciate by more than the interest rate differential you gave away in the Fwd price. So the worst case is if the FC appreciates, because you have given away the int rate differential in the Fwd price + you have also given away the FC appreciation as well. on the cross-product side - you hedged the expected FC asset value, so if FC asset is worth less than expected you would be over-hedged + you bet the wrong way so you lose double. so I would go with A. (sorry if this has already been said above)