Reading 21 EOC #17

CFA Level III
#1

Can anyone explain the answer the CFA provides for this question?

Q 17.

Subscriber 2_“I have observed that many of the overseas markets for Korean export goods are slowing, while the United States is experiencing a rise in exports. Both trends can combine to possibly affect the value of the won (KRW) relative to the US dollar. As a result, I am considering a speculative currency trade on the KRW/USD exchange rate. I also expect the volatility in this exchange rate to increase.”_

For Subscriber 2, and assuming all of the choices relate to the KRW/USD exchange rate, the best way to implement the trading strategy would be to:

  1. write a straddle.
  2. buy a put option.
  3. use a long NDF position.

Answer:

C is correct. Based on predicted export trends, Subscriber 2 most likely expects the KRW/USD rate to increase (i.e., the won—the price currency—to depreciate relative to the USD). This would require a long forward position in a forward contract, but as a country with capital controls, a NDF would be used instead. (Note: While forward contracts offered by banks are generally an institutional product, not retail, the retail version of a non-deliverable forward contract is known as a “contract for differences” (CFD) and is available at several retail FX brokers.)

A is incorrect because Subscriber 2 expects the KRW/USD rate to increase. A short straddle position would be used when the direction of exchange rate movement is unknown and volatility is expected to remain low.

B is incorrect because a put option would profit from a decrease of the KRW/USD rate, not an increase (as expected). Higher volatility would also make buying a put option more expensive.

How was I supposed to know that Korea was implementing capital controls? Is it tacitly said and I missed it or is this purely a deduction exercise?

#2

It doesnt matter if they have capital controls. Without that in the explanation, the anwwer still correct because cash is king. NDF pays cash.

A isn’t corerect becuase a short straddle is a losing strategy on increasing volatility

B is incorrect because expectation is on an increase not a decrease.

C is correct because you want a long forward, NDF or not.

1 Like
#3

Well I think this one comes down to more of reasoning and they just wanted to throw in NDF as one of the EOC questions. Anyways, If volatility increases you would want to buy/long a straddle or a strangle. Since exports in the US relative to Korea is going to be higher more people are demanding the USD and this would mean an appreciation in USD. Therefore, buying a put wouldn’t make sense and like the answer says increased volatility only makes it more expensive.

#4

How does the KRW/USD exchange rate appreciate here? Wouldn’t a decrease in exports lower inflation, whereas a rise in exports would increase inflation? If we follow Purchasing Power Parity, %Δ in spot price KRW/USD = inflation KRW - inflation USD

“Korean export goods are slowing, while the United States is experiencing a rise in exports”

#5

Increased demand for the US dollar drives up the currency. Vice versa for Korea and the KRW.

#6

good intel in this thread.

#7

You would have to work in FX Cash or Options desk of an investment bank to know that USD/KRW or USD/BRL, USD/INR are NDF currencies.