* EOC problem #16, p. 280. Could someone please explain to me the answer? I get the sense that they’re not hedging because they are naturally hedged now; however, can’t connect all of the dots (wording is confusing, in my opinion). * EOC problem #19, p. 281. Technically, they don’t tell you how to convert annual to monthly VAR in the readings (although the solution’s extremely intuitive). Would they ask a question like this on the exam?
A) Three points:
Company’s income is directly proportional to Oil price
Company’s country is an Oil exporter to US.
Oil prices (in $ terms) +ve correlated to company’s home currency againt dollar
- Hedge - Sell futures
a) If Oil Prices increase, company’s income increases. So increase in income will be offset by the position in futures (loss here since you had sold oil futures & now oil prices has moved up).
Now comes the key. If Oil prices are increasing home currency is supposed to be increasing against dollar due to point 3. (Home currency - appreciates, $ - depreciates). By definition when currency appreciates it exports becomes expensive. So country’s export will reduce to US so does the company’s export to US (reducing Sales.)
b) Oil Prices move down
Decrease in company’s sales would be partially offset by profit on sold oil futures. But decrease in oil prices should lead to company’s home currency depreciation making its export cheaper in US & hence increase in exports.
Both a) & b) suggest that company is exposed to exchange rate risk (i.e. home currency’s appreciation/depreciation has an impact on company Sales. So it is hardly making sense to hedge.
B) If you hedge currency risk
Buy Currency futures
If currency appreciates, oil price will also increase (point 3). Oil price increase will increase income but currency appreciation will decrease sales (exports).
If currency depreciates, oil price should fall down decreasing income but increasing exports.
NOW the company can decide to hegde both risks or hedge neither. If they hedge both they would incur transaction cost.
Hope i made sense.
Yes, they would ask a question like EOC #19. and do you really need them to tell you there are 12 months in 1 annual period? They show you every other way to adjust VAR to other specific time periods.
Plain language applies to the clients only.
Sadly, CFA L3 candidates are not the clients of CFAI.