Chapter 10 Currency Management

Question 1

Base

Answer 1

With respect to a foreign exchange quotation of the price of one unit of a currency, the currency referred to in “one unit of a currency.”

Question 2

Basis risk

Answer 2

The risk resulting from using a hedging instrument that is imperfectly matched to the investment being hedged; in general, the risk that the basis will change in an unpredictable way.

Question 3

Bid price

Answer 3

In a price quotation, the price at which the party making the quotation is willing to buy a specified quantity of an asset or security.

Question 4

Carry trade

Answer 4

A trading strategy that involves buying a security and financing it at a rate that is lower than the yield on that security.

Question 5

Cross hedge

Answer 5

A hedge involving a hedging instrument that is imperfectly correlated with the asset being hedged; an example is hedging a bond investment with futures on a non-identical bond.

Question 6

Currency overlay programs

Answer 6

A currency overlay program is a program to manage a portfolio’s currency exposures for the case in which those exposures are managed separately from the management of the portfolio itself.

Question 7

Delta hedging

Answer 7

Hedging that involves matching the price response of the position being hedged over a narrow range of prices.

Question 8

Domestic asset

Answer 8

An asset that trades in the investor’s domestic currency (or home currency).

Question 9

Domestic currency

Answer 9

The currency of the investor, i.e., the currency in which he or she typically makes consumption purchases, e.g., the Swiss franc for an investor domiciled in Switzerland.

Question 10

Domestic-currency return

Answer 10

A rate of return stated in domestic currency terms from the perspective of the investor; reflects both the foreign-currency return on an asset as well as percentage movement in the spot exchange rate between the domestic and foreign currencies.

Question 11

Dynamic hedge

Answer 11

A hedge requiring adjustment as the price of the hedged asset changes.

Question 12

Foreign assets

Answer 12

Assets denominated in currencies other than the investor’s home currency.

Question 13

Foreign currency

Answer 13

Currency that is not the currency in which an investor makes consumption purchases, e.g., the US dollar from the perspective of a Swiss investor.

Question 14

Foreign-currency return

Answer 14

The return of the foreign asset measured in foreign-currency terms.

Question 15

Forward rate bias

Answer 15

An empirically observed divergence from interest rate parity conditions that active investors seek to benefit from by borrowing in a lower-yield currency and investing in a higher yield currency.

Question 16

Funding currencies

Answer 16

The low-yield currencies in which borrowing occurs in a carry trade.

Question 17

Hedge ratio

Answer 17

The relationship of the quantity of an asset being hedged to the quantity of the derivative used for hedging.

Question 18

Home currency

Answer 18

Domestic currency The currency of the investor, i.e., the currency in which he or she typically makes consumption purchases, e.g., the Swiss franc for an investor domiciled in Switzerland.

Question 19

Intrinsic value

Answer 19

The difference between the spot exchange rate and the strike price of a currency option.

Question 20

Investment currencies

Answer 20

The high-yielding currencies in a carry trade.

Question 21

Knock-in/knock-out

Answer 21

Features of a vanilla option that is created (or ceases to exist) when the spot exchange rate touches a pre-specified level.

Question 22

Minimum-variance hedge ratio

Answer 22

A mathematical approach to determining the optimal cross hedging ratio.

Question 23

Non-deliverable forwards

Answer 23

Forward contracts that are cash settled (in the non-controlled currency of the currency pair) rather than physically settled (the controlled currency is neither delivered nor received).

Question 24

Offer price

Answer 24

The price at which a counterparty is willing to sell one unit of the base currency.

Question 25

Overbought

Answer 25

When a market has trended too far in one direction and is vulnerable to a trend reversal, or correction.

Question 26

Oversold

Answer 26

The opposite of overbought; see overbought.

Question 27

Put spread

Answer 27

A strategy used to reduce the upfront cost of buying a protective put, it involves buying a put option and writing another put option.

Question 28

Resistance levels

Answer 28

Price points on dealers’ order boards where one would expect to see a clustering of offers.

Question 29

Seagull spread

Answer 29

An extension of the risk reversal foreign exchange option strategy that limits downside risk.

Question 30

Static hedge

Answer 30

A hedge that is not sensitive to changes in the price of the asset hedged.

Question 31

Stops

Answer 31

Stop-loss orders involve leaving bids or offers away from the current market price to be filled if the market reaches those levels.

Question 32

Support levels

Answer 32

Price points on dealers’ order boards where one would expect to see a clustering of bids.

Question 33

Time value

Answer 33

The difference between the market price of an option and its intrinsic value, determined by the uncertainty of the underlying over the remaining life of the option.