liquidity needs and currency hedge

2014 cfa text vol 5, page 276. q1.

an example from the cfa text is confusing me. hope someone could clarify for me.

if a client requests withdrawal from a fund, and the fund is just rebalanced for currency hedge. what should happen to the currency hedge after the withdraw?

a. do nothing

b. reduce the hedge ratio

c. over-hedge by using currency options.

thanks in advance

I think - hedge ratio should be reduced.

Why I think so? Portfolio was just balanced for the hedge. So it is now balanced (after the rebalance). You are reducing the amount of the portfolio - due to the withdrawal. So you need less hedging at this point in time - after funds have been withdrawn.

Do nothing - not an appropriate option - portfolio is now smaller. keeping the hedge the same will cause negative performance impact.

over hedge with currency options - option would not be exercised in case the currency moved in the other direction - but you lose the premium paid - to go long the option - so negative impact on the portfolio.

cpk123, i chose b as well. it’s intuitive to reduce the hedge when the underlying exposure is reduced by the withdrawal.

the answer is however a. the explanation given was that when the the hedge was just rebalanced, the currency risk is at its minimum, and it’s desirable when high liquidity needs arises. this does not make a lot of sense to me.

anyone has explanation why the answer is A?

There is no “after the withdrawal” in the question.

The question is:

[…] Old Galway receives notice that one of its largest investors in the Overseas Investment Trust III has served notice of a large withdrawal from the fund […] Given the sudden liquidity need announced, Doyle’s best course of action with regard to the currency hedge is to:[…]".

No mention of when this withdrawal will take place. It’s just been announced. Could be next week, could be next month…​

The answer is ‘Do nothing’ because “After rebalancing [this is key: the decision is whether to adjust the dynamic hedge after the recent rebalance but before the withdrawal], the Overseas Investment Trust III is fully hedged; currency risk is at a minimum, which is desirable if liquidity needs have increased [i_ncrease in liquidity needs indicate withdrawal has not taken place yet_]”. ​

As an aside, for those who are studying on the 2015 or 2016 books, this question is in book 4 (not 5). R19. Currency Management.

^ I agree, I’m glad I came to your post here before responding to Quinn here:

The key to this solution is that the withdrawal has been announced but has yet to take place.