Testa’s association with HNW began in 2009 as he was about to undertake a position in a Spanish packaging company.
The Spanish investment involved Testa acquiring 200,000 shares of a packaging company at EUR90 per share. He decided to fully hedge the position with a six-month USD/EUR forward contract. Details of the euro hedge at initiation and three months later are provided in Exhibit 1. Three months after the purchase, the shares had increased to EUR100 each, but Testa, believing that a still higher price was likely, maintained the position. He also indicated that he did not anticipate having to roll the hedge forward at its maturity. Both he and Fournier believed that further appreciation of the euro was quite likely, and the increase in the notional size of the position was hedged using currency options.
If the 2009 forward hedge had been rolled forward at its maturity, using Exhibit 1, the roll yield would most likely have been:
a. negative, but the currency change made it less negative.
b. positive, but the currency change reduced some of this effect.
c. negative, and the currency change made it even more negative.
C is correct. In implementing the hedge, euros (the base currency) must be sold against the US dollar. The base currency is selling at a discount and thus would “roll up the curve” as the contract approaches maturity. Settlement of the forward contract would entail buying euros at a higher price—that is, selling low and buying high—resulting in a negative roll yield. Since the euro has appreciated by the time the hedge needs to be extended, this tends to further increase the cost of euros to settle the original contract and makes the roll yield even more negative—that is, sell low, buy even higher.
So, we have a backwardation here? Can someone please explain why the roll yield would be negative? Either it is a badly-worded question, or I do not get something, because I did not understand the question, nor the solution. Thanks!