9-19 Currency Management

Question 0

Formula for standard deviation of return in domestic currency

Answer 0

O^2 = (w1^2)(o1^2) +(w2^2)(o2^2) + 2w1w2o1o2P
O^2 appox. o1^2 + o^2 + 2o1o2P

For two assets denominated in two different currencies, calculate individual stand deviations then apply weights last

Question 1

Formula for Return on domestic currency, R(dc)

Answer 1

R(dc) = (1+R(fc))x(1+R(fx)) -1

For two different assets denominated in different currencies, calculate the R(dc) individually and then apply weights last.

Question 2

formula for standard deviation in domestic currency, if asset is a risk free asset

Answer 2

O(dc) = O(fx) x (1+R(fc))

Question 3

3 reasons against perfect hedging

Answer 3

1. expensive to apply perfect hedge - requires constant rebalancing
2. no opportunity for enhanced return from appreciating foreign currency (which means higher returns in domestic currency when converted) in short-term
3. currencies can negate themselves or create natural hedges against each other. e.g. two assets denominated in NZD and AUS which are highly correlated - underweight one and overweight the other - if currencies change, will create offsetting effect on portfolio

Question 4

4 currency management strategies

Explain characteristics

Answer 4

1 passive hedging - rules based; tries to match benchmark currency exposures; goal is to eliminate currency risk
2 discretionary hedging - allows specified % deviations; goal is to reduce currency risk while gaining from small currency bets
3 active hedging - allows even greater deviations; goal is to generate active returns, not to reduce currency risk
4 currency overlay - outsourced mgmt of currency; goals are diverse (can be any of the above)

Question 5

7 factors that shift decision to fully hedged strategy

Answer 5

1 short time horizon (for portfolio objectives, so can’t afford to lose money)
2 high risk aversion (don’t want to take currency bets)
3 low hedging costs (if it’s cheap to hedge, why not do it)
4 client doubts the benefit of discretionary management
5 client is not concerned about missed opportunity of gaining from ST currency returns
6 immediate income needs and liquidity needs (so can’t afford to take more risk)
7 significant foreign currency bond exposure (already so want to hedge some of it)

Question 6

List 4 approaches to active currency trading strategies

Answer 6

Note: they all don’t work consistently

1 economic fundamentals
2 technical analysis
3 carry trade
4 volatility trading

Question 7

explain active currency trading strategy based on Economic Fundamentals

Answer 7

• assumes relative PPP holds

- relative PPP says exchange rates converge to fair value in LT but can deviate in ST due to unexpected events

Question 8

5 factors that increase value of currency in ST

this question is part of the Economic Fundamentals based active currency trading strategy

Answer 8

• currency has higher real or nominal interest rates (assuming inflation is constant)
• currency has lower inflation relative to other countries
• currency has greatest rate of increase in fundamental value
• currency is more undervalued relative to fundamental value
• currency of country with decreasing risk premium

Question 9

explain 3 principles of technical analysis of currency

Answer 9

1 past price can predict future price movement, and since fundamental analysis is reflected in those prices no need to analyze info any further
2 investors exhibit irrational behavior in similar ways in similar events and therefore past price and volume patterns tend to repeat
3 doesn’t matter what prices should be worth (intrinsic value), it only matters to know where it will trade

Question 10

list the three major characteristics of Carry Trade

Answer 10

1. it’s an unhedged position
2. assumes that uncovered IRP is violated
3. forward rate is an unbiased predictor of future expected spot rates

Question 11

formula forward discount and premium

Answer 11

forward discount is when F < S

forward premium is when F > S

Question 12

what is uncovered interest rate parity

Answer 12

an int’l parity relationship asserting that forward exchange rate calculated by covered IRP is an unbiased estimate of the spot exchange rate that will exist in the future. If this were true:

• currency with higher i rate will depreciate by amount of initial i rate differential
• currency with lower i rate will appreciate by amount of initial i rate differential

Question 13

explain why carry trade can actually make money from violation of IRP

Answer 13

• higher i rate currency does not depreciate by that exact amount of initial i rate differential but depreciates less or even appreciates
• lower i rate currency does not appreciate by that exact amount …
• borrow lower i rate currency (funding currency from developed country) and invest in higher i rate currency (investing currency from emerging market country)
• NOTE: only works in stable markets not crisis

Question 14

explain the risks in carry trade

Answer 14

• in a few extreme cases, higher i rate currency depreciates substantially more than predicted by IRP and carry trade generates huge losses
• emerging markets are highly volatile especially during crises and can generate huge losses on carry trade
• thus, when exchange rate volatility rises, traders exit their carry trade positions

Question 15

explain Volatility Trading as an active currency management strategy

some cheaper alternatives

Answer 15

can use options to profit from correctly predicting changes in currency volatility

• if expect volatility to increase, buy straddle (buy ATM call and put)
• if expect volatility to decrease, short straddle

cheaper alternative is to buy strangles - OTM puts and calls with the same absolute delta

Question 16

advantages of forward contracts for currency hedging (as opposed to futures)

Answer 16

• customized
• almost any currency pairs available
• no margins (periodic cash flows) required
• more liquid bc trading volume is much larger

Question 17

what is Roll Yield

formula

huge assumption

Answer 17

• return from the movement of forward price over time toward the spot price of an asset
• profit/loss on a forward or futures contract if the spot price is unchanged at contract expiration

(F-S)/S

huge assumption is holding spot price constant over time

Question 18

what are contango and backwardated markets

roll yields

Answer 18

contango

• F > S so price falls to spot
• short position gains and has positive roll yield

backwardation

• F < S so price rises to spot
• short position loses and has negative roll yield

Question 19

ways to reduce opportunity cost in forward hedging

Note: locking in forward price to hedge currency risk eliminates downside but also upside opportunity

Answer 19

discretionary hedging
-over or under hedge with forward contracts based on mgr’s view (if expect CHF to appreciate, then reduce the hedge ratio, hedging less than full exposure to the risk)

option-based hedging (highest to lowest cost)

• Buy ATM put (protective put)
• Buy OTM put
• Collar or Risk reversal (buy put and write call with same deltas - cheaper than ATM)
• Put spread (buy OTM puts and sell puts further OTM)
• Seagull spread (put spread + sell call)

Question 20

what is cross hedge

Answer 20

• proxy hedge or indirect hedge

- introduces additional risk - imperfect correlation of returns between hedging instrument and position being hedged

Question 21

what is macro hedge

Answer 21

type of cross hedge that uses a basket of currencies instead of a single currency

• may contain currencies that I don’t need exposure to, but is a cheaper alternative
• need to do cost/benefit analysis

Question 22

what is minimum-variance hedge ratio

Answer 22

mathematical approach to determining optimal cross hedging ratio, which minimizes tracking error btw hedged asset and hedging instrument

• is a regression of past changes in portfolio value R(dc) to past changes in value of hedging instrument to minimize tracking error between the two
• hedge ratio would be the beta (slope coefficient) of regression
• hedge ratio is based on historical returns so may not perform well
• hedge ratio = P x O(change in dc value of hedged asset) / O(change in dc value of hedging instrument)

Question 23

determine hedge ratio for following scenarios:

• strong positive P between R(fx) and R(fc) increases volatility of R(dc)
• strong negative P between the two decreases volatility of R(dc)

Answer 23

• hedge ratio greater than 1 would reduce vol of R(dc)
• e.g. Japan is heavily dependent on imported energy. If yen appreciates then imports are cheaper so decreases production costs and increases profits
• hedge ratio less than 1 would reduce vol of R(dc)
• e.g. yen depreciates then exports are less competitive and profits fall

Question 24

challenges for managing emerging market currency exposures

Answer 24

• low trading volume leads to larger bid/ask spreads
• lower liquidity and higher transaction costs (bad when trying to exit carry trades)
• transactions between 2 emerging market currencies are even costlier
• emerging market currencies return distributions are non-normal (negative skew of returns)
• higher yield of emerging market currencies lead to large forward discounts and this produces negative roll yield
• contagion is common. the very time diversification is most needed, tends to disappear
• there is tail risk

Question 25

what are non-deliverable forwards

Answer 25

cash settlement in developed market currency because emerging market governments restrict movement of currency in and out of country to settle derivative transactions