Currency Risk Management - R35 Flashcards
What is Translation risk?
What is Economic risk?
What is the formula when you regress unhedged domestic return on teh futures return to determine the optimal hedge ratio, h?
Translation risk is the risk associated with translating the value of the asset back into the domestic currency. The optimal hedge ratio to compensat for translation risk is 1.0, which means that 100% of th principal should be hedged.
Economic risk is the risk associated with the relationship between exchange rate changes and changes in the asset values in the foreign market. This hedge (hE), depends upon the covariance of local asset returns and currenc movements.
Break down the optimal hedge ratio, h, into its two components.
The optimal hedge ratio is the sum of hT and hE.
hT = the portion of the hedge ratio that compensates for translation risk.
hE = the portion of the hedge ratio that compensates for economic risk.
Explain basis risk in spot and futures exchange ratios.
Describe the formula that describes the relationship between spot and futures exchange rates and local interest rates (Interest rate parity).
Basis risk is the difference between the spot and futures exchange rates at a point in time. The magnitude of the basis depends upon the spot rate and the interest rate differential between the two economies.
If the ratio of the interest rates should change, the ratio of the futures rates to the spot rate changes accordingly.
E.g. if the domestic interest rate increases relative to the local rate, the futures rate also increases (i.e., the domestic currency depreciates relative to the local currency).
Discuss the choice of contract maturity in constructing a currency hedge, including the advantages and disadvantages of different maturities
Benefits of short-term
- Better tracking spot exchange rates
- More volume
- More liquidity
Benefits of long-term
- No roll-over
You can match the maturity, roll it over, or extend beyond the date.
Explain the issues that arise when hedging multiple currencies
Can perform a sort of return-based style analysis. Rather than determine the optimal hedge ratio for each individual currency, the manager can regress the portfolio’s historic domestic returns on the futures return for a few major, actively traded currencies
Rd = a + h1F1 + h2F2 + h3F3 + e
where hi = the optimal hedge ratio for currency i
Fi = the return on currency future i
Discuss the use of options rather than futures/forwards to manage currency risk.
The primary benefit to using currency options rather than futures to protect against translation losses is the relative nature of their payoffs.
The payoff to a futures contract is symmetric. A put option, is used like insurance.
Evaluate the effectiveness of a standard dynamic delta hedge strategy when hedging a foreign currency position
Delta, ð, shows how the value of the option changes in response to small changes in the underlying exchange rate. It is calculated as the change in the option premium divided by the change in the exchange rate.
Delta indicates the number of options to purchase to hedge translation risk. Specifically, for every unit of currency, we should hold (-1/ð) put options
Discuss and justify the methods for managing currency exposure, incuding the indirect currency hedge created when futures or options are used as a substitute for the underlying investment.
One way to manage currency exposure is buying options or futures on the foreign assets, instead of the assets themselves.
The options premiums are exposed to translation risk. This is indirect currency hedging, as the investor can enjoy the profits associated with the assets without incurring currency exposure.
Discuss the major types of currency management strategies specified in investment policy statements.
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Balanced Mandate
- The manager has responsibility for managing the portfolio and currency exposure
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Currency Overlay
- Separate manager follows IPS
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Separate Asset Allocation
- Managed by a separate manager under separate guidelines.
