A PM decides to hedge his accounts foreign currency exposure through the use of a forward contract. This is equivalent to: 1. Long foreign cash and short domestic or base currency cash 2. Short foreign cash and long domestic or base currency cash 3. Paying the foreign short term interest rate and recieving the domestic short term interest rate
2?
3 is the right answer. 1)Currency risk + market risk = DRFR 2)Market risk only =FRFR 3)Subtract the two=1-2= Currency Risk hedge = DRFR-FRFR
If he has foreign holdings, to hedge that he’s going to short the foreign futures, which means he’s short the currency (which he’ll be delivering) and long the domestic currency (which he’ll be receiving).
I think Captain is right… we are in effect receiving domestic risk-free rate when we try to hedge the currency risk… we are simply eliminating any exchange rate movements… but then the question is, why not 2?
seems like a poorly constructed question… answers aren’t mutually exclusive. couldn’t both 2 & 3 be true?
Stalla’s answer. Choice A is correct. A forward currency purchase is the equivalent to being long foreign cash (recieving the foreign short term interest rate) and short the domestic or base currency, cash (paying the domestic short term interest rate). My question - WTF? If you are long foreign stocks to sell the foreign and recieve domestic. Is Stalla off here or am I missing something?
wow… what a poorly constructed question…
1morelevel Wrote: ------------------------------------------------------- > Stalla’s answer. > > Choice A is correct. A forward currency purchase > is the equivalent to being long foreign cash > (recieving the foreign short term interest rate) > and short the domestic or base currency, cash > (paying the domestic short term interest rate). > > My question - WTF? If you are long foreign stocks > to sell the foreign and recieve domestic. Is > Stalla off here or am I missing something? Stalla’s off - that’s what you get for messing with a second rate study notes provider. Schweser is never wrong. But to the point, it’s a poorly constructed question (as arguments can be made for both 2 and 3), and it’s wholly incorrect, in that “A” is the only answer that is without a doubt wrong.
Actually, “A” could be correct if you assume that the PM did a naked short on the foreign currency or shorted a foreign index or whatever. Regardless, it’s a dumb question, everybody forget about.