R18 - Currency Management Intro (p2)

Question 1

Pros of currency forwards over futures?

Answer 1

• can be customized by date and amount
• available on any currency pair
• avoid cost and complexity of margin cash flows
• more liquid than futures

Question 2

What is roll yield?

Answer 2

Change in forward price minus change in spot price
(Ft-Fo)-(St-So)

Can be considered a cost of hedging

Question 3

What is a minimum variance hedge ratio?

Answer 3

Regress two items and find hedge ratio that minimizes risk

Question 4

Define a cross hedge

Answer 4

Hedged item and hedging vehicle are highly, but not perfectly correlated

Question 5

What is a macro hedge?

Answer 5

Hedge portfolio-wide risk, rather than single currency

Question 6

Challenges posed in currency trading by emerging market currencies?

Answer 6

• lower trading volume and wider bid-ask spreads
• bid-ask between EM currencies are particularly wide because dealer executes trades between each currency and the DM currency first
• return distributions have negative skews and fat tails, while many strategies assume a normal distribution
• higher int rates produce negative roll yield for sellers of EM currencies
• Tail risk is common because gov artificially supports currency and there are periods of severe corrections

Question 7

What is a Nondeliverable Forward (NDV)?

Answer 7

Some EM goes restrict transactions in their own currency so NDFs settle in a single exchange of gain/loss using the DM currency