Currency Management Flashcards
- Bid price
- Offer price
- The bid price is the price, defined in terms of the price currency, at which the counterparty providing a two-sided price quote is willing to buy one unit of the base currency.
- The offer price is the price, in terms of the price currency, at which that counterparty is willing to sell one unit of the base currency
Calculating the forward rate (using forward points)
= spot rate + (number of basis points / 10 000)
Calculating the present value of a mark-to-market currency cash flow
- Cash flow = (closing rate - original rate) * notional
- Present value = cash flow / (1 + annualized LIBOR [number of days / 360])
Domestic-currency return
- RDC is the domestic-currency return (in percent)
- RFC is the foreign-currency return
- RFX is the percentage change of the foreign currency against the domestic currency (the price currency must be the domestic currency)
Variance of the domestic-currency return
Variance of the domestic-currency returns for the overall foreign asset portfolio
- Each Ri equals the variance of the domestic return σ2(RDC)
Uncovered interest rate parity
- Asserts that, on a longer-term average, the return on an unhedged foreign-currency asset investment will be the same as a domestic-currency investment
- %ΔSH/L is the percentage change in the SH/L spot exchange rate (the low-yield currency is the base currency)
- iH is the interest rate on the high-yield currency
- iL is the interest rate on the low-yield currency
Covered interest rate parity
Carry trade and forward rate bias implementation
- Forward premium/discount = FP/B - SP/B
- Both strategies earn a positive roll yield
- Currency alpha
- Currency beta
- Managing the active FX exposure
- Managing the hedge
Trading the forward rate bias
Involves buying currencies selling at a forward discount, and selling currencies trading at a forward premium
Currency management strategies
Forward currency premium/discount relation to the yield
- Low-yield currency will trade at a forward premium
- High-yield currency will trade at a forward discount
Straddle
A combination of both an at-the-money (ATM) put and an ATM call. A long straddle buys both of these options. Because their deltas are –0.5 and +0.5, respectively, the net delta of the position is zero; that is, the long straddle is delta neutral
Strangle
A position for which a long position is buying out-of-the-money (OTM) puts and calls with the same expiry date and the same degree of being out of the money
Price when rolling matched swaps
Is the mid-market rate
Ordinary least squares equation
- yt = percentage change in the value of the asset to be hedged
- xt = percentage change in value of the hedging instrument
- β = the optimal hedging ratio
Minimum-variance hedge ratio
Collar
A long position in a put option and a short position in a call option
Risk reversal
A long position in a call option and a short position in a put option
Seagull spread (short)
- Covered call + put spread
- Long position + short OTM call + long ATM put + short OTM put
Seagull spread (long)
- Protective put + call spread
- Long position + long OTM call + short ATM call + long OTM put
- Knock-in options
- Knock-out options
- Created when the price touches a pre-defined level
- Cease to exist when the price touches a pre-defined level
A cross hedge (or proxy hedge)
Occurs when a position in one asset (or a derivative based on the asset) is used to hedge the risk exposures of a different asset (or a derivative based on it)
Roll yield for currency
A positive roll yield results from buying the base currency at a forward discount or selling it at a forward premium. Otherwise, the roll yield is negative (i.e., a positive cost)
Currency alpha value for an overlay portfolio
Will be positive only if the currency alpha has a low correlation with other asset classes in the portfolio
When correlation between foreign currency asset returns and foreign currency is negative
There may be no need to hedge all foreign currency exposure because some currency exposure is desirable from a portfolio diversification perspective
Basis risk
The risk resulting from using a hedging instrument that is imperfectly matched to the investment being hedged
- Passive hedging
- Discretionary hedging
- Active currency management
- Currency overlay
- Currency exposure is kept close to that of a benchmark
- Currency exposure is kept close to that of a benchmark, but the manager has some discretion regarding currency exposure
- Active management of risk exposure for currency
- Active management of risk exposure for currency has been outsourced to a specialized firm
Non-Deliverable Forwards (NDFs)
Used when capital controls exist and delivery in the controlled currency is limited by the local government. The NDF is cash settle using the non-controlled curreny
Cost consideration of hedging
- Trading costs
- Bid-ask spread
- Option premium
- FX swap inflow/outflow create volatility in the organization’s cash account
- Trading infrastructure
- Opportunity cost (forgo any possibility of favorable currency move)
Is it preferable to hedge an international bond or an international equity currency exposure?
Since bonds are less volatile than equities, the currency volatility for bonds is a relatively greater source of risk thank it is for equities. A hedge on the bond currency is therefore prefereable
