CURRENCY MANAGEMENT: AN INTRODUCTION

Question 1

When an investor holds one asset denominated in foreign currency, how can we estimate the variance of the domestic returns of the portfolio.

Answer 1

Variance of return of foreign currency * Variance of return of exchange rate * 2 * standard deviation of return of foreign currency * standard deviation of return of exchange rate * correlation between the two.

Question 2

How can we estimate the standard deviation of the domestic currency returns when our foreign currency assets is a risk free assets

Answer 2

Standard deviation Return foreign exchange * (1 + RC)

Question 3

Identify the different approaches that we can implement in a portfolio regarding currency hedging

Answer 3

Passive hedging : Will take the same currency risk as the benchmark. Same currency exposure.

Discretionary hedging : Allow the manager to deviate slightly from the benchmark currency exposure.

Active Currency Management : Allow manager greater deviation from benchmark currency exposure. Goal is to create alpha from this strategy.

Currency overlay : Manager will treat currency as an asset class and will take positions independent of the other assets in the portfolio. Purely seeking alpha, not risk reduction.

Question 4

What would make a manager shift the strategic decision formulation toward a benchmark neutral or fully hedged strategy.

Answer 4

When the client has :

-A short time horizon for portfolio objectives.

-High risk aversion.

-A client who is unconcerned with the opportunity costs of missing positive currency returns.

-High short-term income and liquidity needs.

-Significant foreign currency bond exposure.

-Low hedging costs.

-Clients who doubt the benefits of discretionary management.

Question 5

Identify the different approaches that a manager can use to help himself implement a tactical decision on currency hedging.

Answer 5

1. Economic Fundamentals
2. Technical analysis
3. Carry trade
4. Volatility trading

Question 6

Based on the economic fundamentals approach, how do factors such as interest rates, inflation differentials, and risk premiums influence the short- to medium-term movements of a currency relative to its fundamental value

Answer 6

Country with higher nominal/real interest rates will see its currency appreciate.

Country with lower inflation relative to other country will see currency appreciate

Lower risk premiums compare to other country will increase the currency.

Question 7

What are the three principals that technical analysis of currency is based

Answer 7

1- Past price data are good predictor of future price movement. Those prices are reflected in fundamentals information , hence no need to analyze those.

2. Human reacts to similar events in a similar ways, hence past patterns should repeat itself.
3. It is unnecessary to know what the currency should we worth (real intrinsic value), its only necessary to understand the price movements based on historical patterns, trends, and market psychology.

Question 8

Identify reason why the forward contract are usually preferred by investor in currency hedging.

Answer 8

1. Are customized while futures are standardized
2. Are almost available for every currency pairs
3. Doesnt require a margin
4. More trading volume, hence are more liquid.

Question 9

Explain the use of minimum variance hedge ratio in currency hedging

Answer 9

it is a regression of the past changes in value of the portfolio (RDC) to the past changes in value of the hedging instrument to minimize the value of the tracking error between these two variables. The hedge ratio is the beta (slope coefficient) of that regression.

Question 10

Explain what are non-deliverable forwards and identify benefit of using them.

Answer 10

Alternative of regular forward contract that only requires cash settlement of gains or losses in the developed currency.

Benefit of NDFs : Lower credit risk since we only have to deliver the gains/losses instead of the whole notional amount.