Reading 19 Example 5 Hedging Problems

On the CFAI textbook 4 Session 9 Reading 19 Example 5:

Question 3 Given the data in the table, the roll yield on this hedge at the forward contracts’ maturity date is most likely to be: Correct Answer is Negative.

Solution says,

To implement the hedge, Brixworth & St. Ives must sell MXN against the GBP, or equivalently, buy GBP (the base currency in the P/B quote) against the MXN. The base currency is selling forward at a premium, and—all else equal—its price would “roll down the curve” as contract maturity approached. Having to settle the forward contract means then selling the GBP spot at a lower price. Buying high and selling low will define a negative roll yield. Moreover, the GBP has depreciated against the MXN, because the MXN/GBP spot rate declined between one month ago and now, which will also add to the negative roll yield.

(Institute 27)

Institute, CFA. 2015 CFA Level III Volume 4 Fixed Income and Equity Portfolio Management. Wiley Global Finance, 2014-07-14. VitalBook file.

The citation provided is a guideline. Please check each citation for accuracy before use.

The question is asking at “This Hedge” = “2 months MXN/GBP forward”, maturity, the roll yield is xxx.

Since we are shorting the “rolling down the curve”, shouldn’t the roll yield be positive?

No, the next forward to ‘rolled into’ is trading at a premium over spot due to CIRP.

The question says they’re long GBP for a hedge with the forward trading at a premium (indicating the term structure is in contango). As time goes on, this ‘premium’ value will converge with the spot rate. When expiration arrives and you’re ready to sell the expiring forward and repurchase the next forward @ T=1, you’ll be buying back the premium that was lost in the intial forward that coverged to spot.

Check out this real life example of the forward rate curve for USD/EUR

http://www.followingthetrend.com/term-structure/?ticker=CU

This blue blue is dominating me.

They flip shit around, and you can’t just put the foreign currnecy in the base, since the answers are the other way.

So you kind of need to answer everything in the opposite… Selling MXN against the GBp means ubying GBP, the base currency in the MXN/GBP quote.

Anyone know how to think through this one?

The Fund also has an unhedged foreign-currency asset exposure denominated in the South African rand (ZAR). The current mid-market spot rate in the ZAR/GBP currency pair is 5.1050.

Assuming that all ZAR/GBP options considered have the same notional amount and maturity, the most expensive hedge that Brithworth and St Ives could use to hedge its ZAR exposure is a long positon in an:

atm call, 25-Delta call, or put with a strike of 5.1050.

I thought i got it, but then switched my answer and got it wrong. Since you had a posiiton in ZAR, you need to short the forward ZAR in order to hedge it. Either that or you need to buy the GBP. So this would be a put on the ZAR or a call on the GBP. But the question has it flipped still… so you do the ATM call right?

THANKS!

I am guessing the option is on the base currency. In your case, you need to buy base currency. Hence need a Call. Pricing are just some disctraction.

any other comments?

Thanks for your help.

Yeah I remember this BB gave me a headache.

Always think in terms of the base currency. It is basically what you are selling or buying.

If you need to buy or sell in the other currency, just do the opposite onthe base currency.

  1. Determine what the base is

  2. Buying or selling base

  3. Is the base trading at forward premium/discount (buy at discount = positive roll yield ,etc)

  4. is the base expected to appreciate or depreciate (unhedge if buying and expected to depreciate)