Currency Mgt Flashcards
FX Swap
An FX swap transaction consists of offsetting and simultaneous spot and forward transactions, in which the base currency is being bought (sold) spot and sold (bought) forward. These two transactions are often referred to as the “legs” of the swap. The
two legs of the swap can either be of equal size (a “matched” swap) or one can be larger than the other (a “mismatched” swap).
FX swaps are distinct from currency swaps. Similar to currency swaps, FX swaps involve an exchange of principal amounts in different currencies at swap initiation that is reversed at swap maturity. Unlike currency swaps, FX swaps have no interim interest payments and are nearly always of much shorter term than currency swaps.
MVHR (Minimum Variance Hedge Ratio)
The minimum-variance hedge ratio (MVHR) is a mathematical approach to determining the hedge ratio. Regress past changes in value of the portfolio (RDC) to the past changes in value of the hedging instrument (the foreign currency) to find the hedge ratio that would have minimized standard deviation of RDC. The hedge ratio is the beta (slope coefficient) of that regression.
Positive correlation between RFX and RFC; MVHR > 1.
Negative correlation between RFX and RFC; MVHR < 1.
Macro hedge
A macro hedge is a type of cross hedge that addresses portfolio-wide risk factors rather than the risk of individual portfolio assets. One type of currency macro hedge uses a derivatives contract based on a fixed basket of currencies to modify currency exposure at a macro (portfolio) level.
Cross hedge
A cross hedge (sometimes called a proxy hedge) uses a hedging vehicle that is different from, and not perfectly correlated with, the exposure being hedged.
Non-deliverable forwards (NDFs)
Non-deliverable forwards (NDFs) are forward contracts in which the exchange of the notional amounts of the currencies are not required. NDFs are an alternative to deliverable forwards and allow for the gains or losses of an emerging market’s restricted currency to be settled in a developed market currency, which lowers credit risk. Only the gains to one party are paid at settlement.
Tilting the Delta neutral positions
Different no. of calls vs. putts will tilt the Straddle or Strangle
Hedging is not free
Forwards
- no or minimal initial cost
- high opportunity cost as potential upside of hedged currency is eliminated
Purchasing options has high initial cost but retains the upside of the hedged currency (the protective put strategy).
Lowering the cost of hedge
– Lowering the cost of the hedge will require some combination of less downside protection or upside potential.
some combination of:
-Writing options to generate premium inflow.
-Adjusting the option strike prices.
-Adjusting size (notional amount) of the options.
-Adding exotic features to the options.
Inflation rate in NZ higher than JPY
- Depreciation in exchange rate JPY / NZ
- reduced capital flows from JPY to NZ
All else equal, an increase in New Zealand’s inflation rate will decrease its real interest rate and lead to the real interest rate differential favoring Japan over New Zealand.
Deltas for Volatility Strategies
Deltas for puts range from -1 to 0.
* OTM puts have deltas between 0 and -0.5.
* ATM puts have delta = -0.5.
* Deltas for calls range from 0 to +1.
* OTM calls have deltas between 0 and +0.5.
* ATM calls have delta = +0.5.
The 10-delta option is deeper OTM and hence cheaper than the 25-delta option. This implies that a 10-delta strangle would be less costly and would have a more moderate risk-reward structure than that of a 25-delta strangle.
The % change in the premium for a 5-delta option for a given % change in the spot exchange rate will be higher than the % change in premium for a 25 delta option. This implies that a very low delta option is like a highly leveraged lottery ticket on the event occurring.
Resistance and Support for exchange rates levels
-Resistance lies above the current spot rate level if the 200 day moving average is higher than spot rate.
-Support would be below the spot rate if the 200 day moving average was lower than the spot rate or if the Spot rate had already reached the moving average .
Costs of hedging internally
- Bid/Offer spread charged by dealers for trading/rebalancing hedges
- Long position in currency option requires upfront costs
- OTM options expiring unrecoverable costs
- Rolling forward requires cash settlement
- Admin / Overhead (personnel & tech)
Effect of increase in correlation between Rfx and RFC
An increase in the expected correlation between movements in the foreign-currency asset returns and movements in the spot rates from 0.50 to 0.80 would increase the domestic-currency return risk but would not impact the expected domestic-currency return.
Compare types of Hedging strategies
- Passive
- Discretionary
- Active
Passive - no discretion and aim is to keep FX risk close the benchmark. It is rules-based approach
Discretionary (usually with limit 5-10%) - primary goal of a discretionary hedging approach is to protect the portfolio from currency risk while secondarily seeking alpha within limited bounds
Active - primary goal is to take currency risks and manage them for profit with a secondary goal of protecting the portfolio from currency risk
Determining the direction of hedge (buy/long vs. sell/short)
Based on the exposure to currency. If long on USD Assets then sell forwards since to settle the forwards we will need to buy USD (or generate USD from selling our USD based asset which will be required and hence the hedge)
