Streusel decides invest in a single overseas stock and hedge his currency exposure. The stock he chooses is called Abel Enterprises, a Turkish based trading company, specializing in exporting medical equipment to France and Germany that is surplus to requirements for the Turkish Health Service. The investment will amount to $10m. New Turkish Lira (TRY) are currently at 1.4 TRY to 1 USD. Forward currency curves are flat. Streusel asked his assistant, Sarah to analyse the historic returns of Abel against value changes to Turkish Lira. Sarah plots returns to Abel Enterprises against returns to the Turkish Lira in USD and plots a regression line. The gradient of the regression line is 0.6. Regrettably by the time Sarah presents her results to Streusel she has forgotten whether the gradient was positive or negative. 1 Assuming Streusel wishes to hedge the foreign currency risk of principal investment, which of the following trades should he enter into? A) Sell 10m TRY forward B) Sell 14m TRY forward C) Buy 14m TRY forward D) Buy 10m TRY forward 2 Assuming Streusel wishes to hedge with minimum variance, which of the following trades should he enter into? A) Sell 5.6m TRY forward B) Sell 22.4m TRY forward C) Buy 5.6m TRY forward D) Buy 22.4m TRY forward 3 If Streusel were to delta hedge using put options on Turkish Lira, which of the following most accurately describes what he should do in the event of the Turkish Lira moving to 1.5 TRY to 1 USD to maintain the delta hedge? A) Sell some TRY calls B) Buy some TRY calls C) Buy some TRY puts D) Sell some TRY puts
- B 2) min variance, wtf? 3) B?
- B - he is long the TRY so wants to hedge the currency risk by going short the TRY and its full notional amount 2) Agree with BPB - wtf? 3) C- i believe whenever you are using options to hedge currency you buy puts. I think this is always the case.
B A C
B He needs to sell 14m TRY forward because this is equivalent to a $10m investment. A The gradient will have a negative slope as Abel is an exporter and will benefit when the TRY weakens. The minimum variance hedge ratio is therefore 1 – 0.6 = 0.4. Therefore only 14m x 0.4 TRY needs to be sold forward ie 5.6m TRY. D Delta hedging using put options involves buying puts. Assuming the puts were ATM he would need to buy puts on 28m TRY to delta hedge. If TRY moves to 1.5 to 1 this represents a strengthening of and a weakening of TRY. The delta of the put options would get closer to -1. This means he would need fewer put options to delta hedge. We would therefore sell some puts to rebalance our delta hedge.
Is that middle question still in the curriculum? That is scary to me I am so unfamiliar with it… the other 2 make sense…
cfaboston28 Wrote: ------------------------------------------------------- > Assuming the puts were ATM he would need to buy puts on 28m TRY to delta hedge. Would you please kindly explain ?
1)B 2)A. Since the company is exporting, if the local currency depreciates, the company’s returns would increase. if the local currency appreciates, the company’s returns would decrease. so -ve slope coefficient , and MVHR is 1-0.6. Sell 0.4 * 14mm TRL forwards. 3)C
cfaboston, For question 3, is the answer D because of the assumed delta change, or simply because the currency weakened? In the absence of mathematical background, the delta may not have changed as much to compensate for the change in currency (i.e. it could be 5 years to expiration and thus have a low gamma), so it is hard to understand why this is the definitive answer. My take was that it was C, as currency weakens there is “more” of it and thus more to hedge. Not having mathematical background to understand how delta changed in relation to how much more delta you need for hedging, I chose C because you simply need more delta for hedging (and thus need to sell a put) What is the best way for me to reconcile this?
1 B 2 A 3 D CFABoston - are you enrolled in the 7C course too? I recognised these questions from their MC mock.
there actually is a good item set on derivs/foreign currency if you guys haven’t done it on the CFAI site- the “sample L3 item set questions”. Only 3 item sets, one ethics, middle is derivs, last one is GIPS (which smoked me AGAIN I hate you GIPS). The derivs one had a few calc q’s sort of similar to this- check it out. Good practice set.
Yes these questions are from 7 City past practice tests. I just copied and paste it. I had no idea what MV was wrt this question
Minimum Variance Hedge Ratio is in SS14-15 Minimum Variance Hedge Ratio = Translation Risk + Economic Risk = 1 + slope of fx return aainst fx movement In this question, this = 1 + (-0.6) = 0.4 0.4 x TRY 14mm = TRY 5.6mm