Revised Currency Flashcards
How do you calculate domestic currency return from foreign currency returns?
Return in DC = (1+FC)*(1+FX) - 1
When calculating the FX effect on returns, what currency are we calculating the return on?
The FX return is the price change in the asset currency, not the home currency. A USD asset owned by a CAD investor would have an FX return based in the app or dep of USD.
How do you find the SD of a portfolio when including the FX and FC returns?
First, this formula assumes that Rfc and Rfx are additive for simplicity. Normal SD formula with weightings of 1 for each.
What does the currency risk management policy of an IPS typically outline?
- Target proportion of passively hedged
- Latitude around target
- Frequency of hedge rebalance
- FX performance benchmark to use
- Hedging tools permitted
What are the two diversification considerations for FX decisions?
- Time horizon
Assumption that currencies will mean revert to some long run value - Asset composition
The correlation of fixed income asset returns and FX returns are higher, therefore often hedged.
What are the cost considerations for FX decisions in a portfolio?
- Trading costs such as spreads, options, forward rolls, and admin overhead.
- Opportunity Costs
Draw the currency risk spectrum
Passive to Discretionary to Active to Speculative
What are eight reasons why a full portfolio hedging strategy could make sense?
- Short term objectives
- Risk averse owners
- High liquidity needs
- High fixed income assets
- Hedging is cheap
- Volatile markets
- Skeptical to benefits of currency alpha
What are the basic principles of a currency management strategy based on economic fundamentals?
- FX relationships are determined by some logical relationships that can be modeled
- PPP will drive FX to long term equilibrium
- Short term rates are driven by interest rate and inflation differentials as well as economic performance
How does the forward rate bias contradict uncovered interest rate parity?
UIRP suggests that all currencies should return the same risk free rate. If a country has a higher yielding currency vs another, it must depreciate to the point where the FX return offsets the additional yield. This is often not the case as forward rates are not unbiased predictors of future spot rates. High yielding currencies should trade at a forward discount
How does increased inflation (in theory) affect the attractiveness, and therefore the FX rate, of a currency?
In general, accelerating inflation without an interest rate policy change would imply a lower real rate of return. This means that the currency would be less attractive to invest in. Capital would flow out of the currency and it would depreciate.
How do you create a 100% passive FX hedge using forwards?
You create an offsetting short position on any FX you are long. You sell the asset currency forward.
What is the difference between a static and dynamic hedge?
A static hedge does not constantly change the hedge ratio to match changes in MV of the portfolio assets. A dynamic hedge will rebalance. The more risk averse you are, the more you will rebalance.
Explain what a positive roll is and how it is technically a carry trade?
A low yield currency will trade at a forward premium, therefore when you sell it forward you will be selling at a higher price than prevailing spot. If the low yield currency is not going to appreciate enough to offset the positive roll yield, then you will make more money hedging. Selling the low currency forward is equivalent to being long the high yield and short the low yield - both positions profit from UIRP not holding.
How can you use options to hedge against an FX asset?
Normally you would need to sell forward - the best way to replicate selling forward would be to buy an ATM put option. The primary differences are that the put provides upside compared to the forward, but the option costs money.
