Can somebody please assist to review the solution appended below the question? I think they mixed the currency conversion around.
Rosario Delgado is an investment manager in Spain. Delgado’s client, Max Rivera, seeks assistance with his well-diversified investment portfolio denominated in US dollars.
Rivera’s reporting currency is the euro, and he is concerned about his US dollar exposure. His portfolio IPS requires monthly rebalancing, at a minimum. The portfolio’s market value is USD2.5 million. Given Rivera’s risk aversion, Delgado is considering a monthly hedge using either a one-month forward contract or one-month futures contract.
Assume Rivera’s portfolio was perfectly hedged. It is now time to rebalance the portfolio and roll the currency hedge forward one month. The relevant data for rebalancing are provided in Exhibit 1.
|One Month Ago||Today|
|Portfolio value of assets (USD)||2,500,000||2,650,000|
|EUR/USD spot rate (bid–offer)||0.8913/0.8914||0.8875/0.8876|
|One-month forward points (bid–offer)||25/30||20/25|
Q. Calculate the net cash flow (in euros) to maintain the desired hedge. Show your calculations.
When hedging one month ago, Delgado would have sold USD2,500,000 one month forward against the euro. Now, with the US dollar-denominated portfolio increasing in value to USD2,650,000, a mismatched FX swap is needed to settle the initial expiring forward contract and establish a new hedge given the higher market value of the US dollar-denominated portfolio. To calculate the net cash flow (in euros) to maintain the desired hedge, the following steps are necessary:
- Buy USD2,500,000 at the spot rate. Therefore, the bid side of the market must be used to calculate the outflow in euros.USD2,500,000 × 0.8875 = EUR2,218,750.
- Sell USD2,650,000 at the spot rate adjusted for the one-month forward points (all-in forward rate). Therefore, the offer side of the market must be used to calculate the inflow in euros.All-in forward rate = 0.8876 + (25/10,000) = 0.8901. USD2,650,000 × 0.8901 = EUR2,358,765.
- Therefore, the net cash flow is equal to EUR2,358,765 – EUR2,218,750, which is equal to EUR140,015.