Currency management

Question 1

Domestic currency return

Answer 1

Rdc= (1+Rfc)(1+Rfx)-1

Question 2

What explains the effect of foreign currency movement in domestic currency return

Answer 2

Rdc=(1+Rfx)(1+Rfc)-1
Rfx+RfxRfc : explains effect of foreign currency movements

Question 3

Cost considerations

Answer 3

1) Trading costs
* bid ask spread offered by dealers for trading
* option premiums
* rolling “forward” forward
* administrative overhead (infrastructure for trading)

2) opportunity cost : foregoe any possibility of favourable currency rate moves. Can be retained with options but at higher cost

Question 4

currency overlay

Answer 4

currency management is outsourced
service may range from passive hedging to active management of existing FX exposures to “forex as an asset class”
allow separation of currency alpha (active management) and currency beta (hedging function)

Question 5

Economic fundamental

Answer 5

FX rate are determined by logical economic relationships that can be modeled. Short term driven by interest rate and inflation differentials as well as economic performance

Question 6

Technological analysis

Answer 6

In a liquid freely traded market, the historical price data already incorporates all relevant info on future price movement

Question 7

Carry Trade

Answer 7

Borrow low yield currencies, invest in high yield currencies

Question 8

Forward rate bias

Answer 8

Buy currencies selling at a forward discount and sell currencies trading at a forward premium

Risk
* volatility of spot rates
* rapid movement in exchange rates associated with a panicked unwinding of carry trades
* usually high yield currency are in high risk countries

Question 9

Volatility trading

Answer 9

Buy options : long volatility - options benefit but assets suffer from rise of volatility
Sell options : short volatility both options and assets suffer if volatility rise

Question 10

Static hedge
Dynamic hedge

Answer 10

Static hedge : unchanging hedge, minimize transaction costs but introduces currency exposure. As soon as P/B, the hedge isn’t adapted anymore
Dynamic hedge: rebalance the hedge periodically. Greater transactions costs compared to static hedge

Question 11

If forward premium on currency A and currency A depreciates => hedge

Question 12

cost reduction strategies

Answer 12

1) over/under hedge using forwards
2) protectve put using OTM options
3) short risk reversal (collar) : buy OTM put, short OTM call
4) put spread : buy a put, sell another deeper OTM put (lower cost and higher premium)
5) seagull spread : put spread + covered call

Question 13

cross hedge

Answer 13

a position in one asset is ised to hedge the risk exposure in another

Question 14

macro hedge

Answer 14

a hedge focused on the entire portfolio
typically defined in terms of risk exposure protection

Question 15

cross/macro hedges introduce basis risk since correlation <1 and can change over time

Question 16

Challenges for managing EM currencies

Answer 16

1) higher transaction cost under normal market condition
2) increase likelihood of extreme market events and severe illiquidity under stressed market conditions

Question 17

Net short volatility

Answer 17

Speculative traders are net short volatility because most options terminate OTM and keep premiums wiithout deliverying underlying currency pair

Question 18

Net long volatility

Answer 18

Hedgers are net long volatility to buy protection for unanticipated volatility

Question 19

3 principles of technical analysis

Answer 19

(1) Historical price data can be helpful in projecting future movements,
(2) historical price patterns have a tendency to repeat and identify profitable trade opportunities,
(3) technical analysis attempts to determine not where market prices should trade but where they will trade