CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r19 currency management IFT notes

FX swaps are used to renew outstanding forward contracts once they mature, to “roll them forward.” A hedge ratio is the ratio of the nominal value of the derivatives contract used to hed

Currency Management: An Introduction

1 Introduction 3

2 Review of Foreign Exchange Concepts 3

2.1 Spot Markets 3

2.2 Forward Markets 3

2.3 FX Swap Markets 4

2.4 Currency Options 4

3 Currency Risk and Portfolio Return and Risk 4

3.1 Return Decomposition 4

3.2 Volatility Decomposition 4

4 Currency Management: Strategic Decisions 5

4.1 The Investment Policy Statement 5

Currency management should be conducted within IPS-mandated parameters 5

4.2 The Portfolio Optimization Problem 5

4.3 Choice of Currency Exposures 6

4.4 Locating the Portfolio along the Currency Risk Spectrum 6

4.5 Formulating a Client-Appropriate Currency Management Program 7

5 Currency Management: Tactical Decisions 8

5.1 Active Currency Management Based on Economic Fundamentals 8

5.2 Active Currency Management Based on Technical Analysis 8

5.3 Active Currency Management Based on the Carry Trade 9

5.4 Active Currency Management Based on Volatility Trading 9

6 Tools of Currency Management 9

6.1 Forward Contracts 9

6.1.1 Hedge Ratios with Forward Contracts 10

6.1.2 Roll Yield 10

6.2 Currency Options 12

6.3 Strategies to Reduce Hedging Costs and Modify a Portfolio’s Risk Profile 13

6.4 Hedging Multiple Foreign Currencies 15

6.5 Basic Intuitions for Using Currency Management Tools 16

7 Currency Management for Emerging Market Currencies 16

7.1 Special Considerations in Managing Emerging Market Currency Exposures 16

7.2 Non-Deliverable Forwards 16

Summary 17

Examples from the Curriculum 19

Example 1 Portfolio Risk and Return Calculations 19

Example 2 Currency Overlay 20

Example 3 Active Strategies 21

Example: Executing a hedge 24

Example 4 The Hedging Decision 25

Example 5 Hedging Problems 26

Example 6 Alternative Hedging Strategies 27

Example 7 Cross Hedges 29

Example 8 Hedging Strategies 31

This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA®

Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright

2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the

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1 Introduction

In this reading we will look at the basic concepts and tools of currency management For a global

portfolio, which can contain many foreign currency denominated assets, effective management of

currency risk is the key to achieving superior returns

2 Review of Foreign Exchange Concepts

In the foreign exchange market, less than 40% of the transactions are direct trades in spot markets The

majority of the transactions (more than 60%) take place in FX derivatives markets, and they are for risk

management purposes

2.1 Spot Markets

In professional FX markets, currencies are identified by standard three-letter codes For example, USD

stands for US dollar, EUR stands for Euro

In the curriculum, exchange rates are quoted using the price/base convention The price currency is in

the numerator and the base currency is in the denominator The base currency is the currency of which

there is one unit Consider the following exchange rate: USD/EUR = 1.3500 Here USD is the price

currency and EUR is the base currency One EUR can be traded for 1.3500 USD

Note: Some vendors use the base/price convention To remain consistent with the curriculum these notes

will use the price/base convention

The spot exchange rate is typically for T + 2 delivery i.e the settlement will take place on the second

business day after the trade date

Exchange rates are quoted in terms of a bid-offer price Bid price is the price (in terms of price currency)

at which a dealer is willing to buy one unit of base currency Offer is the price at which a dealer is willing

to sell one unit of base currency For example, USD/EUR = 1.3648 / 1.3652 Here the dealer will buy 1

EUR for 1.3648 USD and sell 1 EUR for 1.3652 USD

2.2 Forward Markets

Forward contracts are transactions with settlement longer than T + 2 The rate used in forward contracts

is called the forward rate

Forward rates are quoted in terms of forward points Points are simply the difference between the

forward exchange rate quote and spot exchange rate quote To convert quoted points into a forward

rate, divide the number of points by 10,000 and then add the result to the spot rate For example, if the

spot rate is USD/EUR = 1.3549 and the three month forward points are -15.9, then the three month

USD/EUR forward rate = 1.3549 + (-15.9/10,000) = 1.3533

Note: For some currency pairs such as JPY/USD the quoted points need to be divided by 100

The profit or loss from a forward position in the exchange rate market, depends on the type of position

in the currency and whether the currency appreciated or depreciated A summary of possible outcomes

is provided below

Currency appreciates Currency depreciates Long base currency Profit Loss

Short base currency Loss Profit

2.3 FX Swap Markets

An FX swap is a simultaneous spot and forward transaction; one leg of the swap is buying the base

currency and the other is selling it FX swaps are used to renew outstanding forward contracts once they

mature, to “roll them forward.”

A hedge ratio is the ratio of the nominal value of the derivatives contract used to hedge the market

value of the hedged asset

2.4 Currency Options

Currency options are similar to options on other assets (e.g., bonds, equities) The most common type of

options are call and put However, in addition to these vanilla (plain) options, FX markets also have

exotic options Exotic options have a variety of features as compared to vanilla options, which makes

them flexible tools for risk management

3 Currency Risk and Portfolio Return and Risk

This section addresses LO.a:

LO.a: Analyze the effects of currency movements on portfolio risk and return

3.1 Return Decomposition

The return on a foreign asset (in domestic currency terms), is a combination of the return on the asset in

foreign currency terms and the change in the value of the foreign currency (relative to the domestic

currency)

The returns can be calculated as:

𝑅𝐷𝐶 = (1 + 𝑅𝐹𝐶)(1 + 𝑅𝐹𝑋) − 1

For example, suppose that a U.S investor bought Euro denominated bonds The return on the bonds

was 10% and EUR appreciated against the dollar by 5% Then the total return for the U.S investor is

(1 + 10%) (1 + 5%) – 1 = (1.10)(1.05) – 1 = 0.155 = 15.5%

An alternative method to calculate the approximate total return is to simply add the two returns In out

example the total return would be ≈ 10% + 5% ≈ 15%

3.2 Volatility Decomposition

As studied in portfolio management at Level I and Level II, the volatility of a two-asset portfolio can be

calculated as:

𝜎𝑝2= 𝜎𝐴2𝑤𝐴2+ 𝜎𝐵2𝑤𝐵2+ 2𝜌𝑤𝐴𝑤𝐵𝜎𝐴𝜎𝐵

If we assume that one asset is the actual foreign investment and the other asset is the foreign currency

and our weights for both assets is the same, then the above equation can be changed to:

𝜎𝐷𝐶2 = 𝜎𝐹𝐶2 + 𝜎𝐹𝑋2 + 2𝜌𝜎𝐹𝐶𝜎𝐹𝑋

Refer to Example 1 from the curriculum

With respect to Example 1, the key points from the perspective of the European investor are:

The DC is EUR

 This is the price currency

 The exchange rate tells us how many euros does it takes to buy a Canadian dollar

The FC is CAD

 This is the base currency

The RFX is negative because the CAD weakens relative to the euro

 A euro now buys $1.2925, but it is expected to be able to buy $1.3100 in the future

The RFC is negative because it has declined in CAD terms because the value of the investment has gone

from $101.00 to $99.80

4 Currency Management: Strategic Decisions

Section 4 addresses LO.b:

LO.b: Discuss strategic choices in currency management

There are variety of approaches to currency management and there is no consensus on the best way to

manage currency risk Some fully hedge the risk, some don’t hedge at all, while there are some that

actively seek foreign exchange risk in order to generate extra returns

There are two beliefs on currency risk:

Belief 1: In the long-run, exchange rates revert to historical means, therefore currency effects cancel out

to zero

Belief 2: Currency movements can have a dramatic impact on returns

In either case, foreign exchange risk needs to be recognized

4.1 The Investment Policy Statement

Currency risk management is often a segment of the IPS It could cover:

 Target proportion of currency exposure to be passively hedged (e.g 50 percent);

 Latitude for active currency management around this target;

 Frequency of hedge rebalancing (e.g monthly);

 Currency hedge performance benchmark to be used;

 Hedging tools permitted (types of forward and option contracts)

Currency management should be conducted within IPS-mandated parameters

4.2 The Portfolio Optimization Problem

To optimize a multicurrency portfolio, we need to optimize foreign currency assets and FX exposures

Optimization of a multi-currency portfolio of foreign assets involves selecting portfolio weights that

locate the portfolio on the efficient frontier of the trade-off between risk and expected return defined in

terms of the investor’s domestic currency

Many portfolio managers handle asset allocation with currency risk as a two-step process:

1 First they compute portfolio weights for foreign-currency assets that optimize fully hedged

returns

2 Then they can take active currency exposure by deciding how much they want to deviate from

the computed portfolio weights

4.3 Choice of Currency Exposures

Degree of currency exposure spans a spectrum from being fully hedged to actively trading currencies

The following considerations helps us decide what degree of exposure to take

Diversification Considerations

Time horizon: Currency value may fluctuate significantly from their long-run average in the short-term,

but be mean-reverting in the long-run Hence if our time horizon is long, we can have a relatively low

hedge ratio

Asset composition: Foreign currency returns have different correlations with different asset classes For

example, the correlation between foreign-currency returns and foreign-currency asset returns tends to

be greater for fixed-income portfolios than for equity portfolios Hence if we have bonds in our portfolio

a higher hedge ratio would be required

Cost Considerations

It costs money to hedge currency risk, so these have to be balanced against any benefit The two types

of costs to consider are:

Trading costs: These include bid-offer spread, option premiums, and administrative infrastructure for

currency trading

Opportunity costs: This refers to the possibility of missing out on advantageous currency movement

Because of this many currency managers who don’t have a strong view on currency rate movement

often use a hedge ratio of 50% This is called splitting the difference

4.4 Locating the Portfolio along the Currency Risk Spectrum

There is a range of currency exposure – from passive hedging, which has no exposure, to a currency

overlay strategy, which manages currency as separate asset class Refer to the figure below:

Passive

Hedging

Discretionary Hedging

Active Currency Management

Currency Overlay

Passive Hedging

 Keep currency exposures close to, if not identical to, benchmark (RFC = 0);

 Rules-based approach;

 Removes almost all discretion from manager;

 Based in the belief that currency risk exposure is not sufficiently compensated;

 Note: Even passive currency hedges must be periodically rebalanced

Discretionary Hedging

 Similar to passive hedging;

 Neutral benchmark is used, but hedging decisions are not strictly rules-based;

 Deviations of +/-X% may be specified in the IPS;

 For example, a hedge ratio may range from 95% to 105% of portfolio value (with 100% being a

perfect hedge);

 Primary objective is to protect against currency risk;

 Secondary objective is to enhance returns by adjusting currency risk exposure within bounds;

 If the manager has no views, it is assumed that he will maintain a 100% hedge ratio;

 Ultimately, the manager’s performance is still compared to the benchmark

Active Currency Management

 A more permissive form of discretionary hedging;

 Unlike discretionary hedging, the active currency manager is expected to have views, take active

risks, and manage currency for profit (and is paid to do so);

 Maintaining a 100% hedge ratio for extended periods is not an option

Currency Overlay

 Portfolio manager may outsource the management of currency risk exposure to a specialist (in

theory, this could be for the sole purpose of fully-hedging – see Example 2, Q1);

 Here foreign exchange is considered as a separate asset class and currency risk exposure is

managed separately from portfolio assets;

 Refer to Example 2 from the curriculum.

4.5 Formulating a Client-Appropriate Currency Management Program

Section 4.5 addresses LO.c

LO.c: Formulate an appropriate currency management program given market facts and client’s

objectives and constraints

The strategic currency positioning of the portfolio, as encoded in the IPS, should be biased toward a

more-fully hedged currency management program if the clients:

 Have a shorter investment horizon

 Are more risk averse

 Rely on the portfolio as a source of immediate income and/or liquidity

 Hold fixed income assets denominated in foreign currency

 Can implement a low-cost hedging program

 Believe that financial markets are volatile

 Are skeptical about the benefits of active currency management (i.e., believe that markets are

efficient)

5 Currency Management: Tactical Decisions

Section 5 addresses LO.d

LO.d: Compare active currency trading strategies based on economic fundamentals, technical

analysis, carry-trade, and volatility trading

5.1 Active Currency Management Based on Economic Fundamentals

All else equal, the base currency should appreciate if there is upward movement in:

 Its long-run equilibrium real exchange rate;

 Either its real or nominal interest rates, which should attract foreign capital;

 Expected foreign inflation, which should cause the foreign currency to depreciate;

 The foreign risk premium, which should make foreign assets less attractive compared to the

base currency nation’s domestic assets

The long run equilibrium real exchange rate is the anchor for exchange rate In the short run, there can

be movements in either direction of the long-run equilibrium as shown in Exhibit 5

5.2 Active Currency Management Based on Technical Analysis

Technical analysis ignores economic analysis, instead it is based on three themes:

1 In a liquid, freely-traded market, the historical price data can be helpful in projecting future

price movements

2 Patterns in the price data have a tendency to repeat, and that this repetition provides profitable

trade opportunities

3 Unlike fundamental analysis, technical analysis does not attempt to determine where market

prices should trade (i.e., a currency’s intrinsic value), but rather where they will trade

Technical analysis for currency trading:

 Can be useful in identifying market trends and turning points; however, it is less useful in

trendless markets

 Tries to identify when markets have become over-bought or oversold i.e they gave trended too

far in one direction

 Tries to determine the support levels and resistance levels

o 200-day moving average of daily rates is an important indicator or support or resistance

levels

o When 50-day moving average crosses 200-day moving average, a trend may be starting

(“break out”)

5.3 Active Currency Management Based on the Carry Trade

The carry trade is a trading strategy of borrowing in low-yield currencies and investing in high-yield

currencies A summary of the carry trade is presented below:

Implementing the carry trade High-yield currency Low-yield currency

Trading the forward rate bias Forward discount currency Forward premium currency

During times of crisis, there is usually a panicked unwinding of carry trade positions, hence the

expression “picking up nickels in front of a steamroller” Carry trade is most profitable during periods of

low volatility It can be based on borrowing/investing in multiple currencies

5.4 Active Currency Management Based on Volatility Trading

This refers to trading based on a view about future volatility of exchange rates, not the direction of

exchange rates:

 A trader uses delta hedging to hedge away the exposure to changes in FX rates

 The trader then has exposure to other Greeks, the most significant of which is Vega (sensitivity

of option price to volatility underlying FX rate)

One simple option strategy that implements a volatility trade is a straddle, which is a combination of

both an at-the-money (ATM) put and an ATM call

A similar option structure is a strangle position for which a long position is buying out-of-the-money

(OTM) puts and calls with the same expiry date and the same degree of being out of the money The

more OTM the options used to build a strangle are, the cheaper the position will be For example, a

10-delta strangle is cheaper than a 25-10-delta strangle, but has a more moderate payoff structure (see

Example 3, Q4)

Refer to Example 3 from the curriculum

6 Tools of Currency Management

Section 6 addresses LO.e:

LO.e: Describe how changes in factors underlying active trading strategies affect tactical trading

decisions

6.1 Forward Contracts

This section addresses LO.f:

LO.f: Describe how forward contracts and FX (foreign exchange) swaps are used to adjust hedge

ratios

Forward contracts are much more commonly-used for hedging currency risk compared to futures

contracts

6.1.1 Hedge Ratios with Forward Contracts

The basic principle of hedging with forward contracts is to match the current market value of the

foreign-currency exposure in the portfolio with an equal and offsetting position in a forward contract

However, the practical challenge that managers face is that the market value of the foreign-currency

assets will change with market conditions Actual hedge ratio will drift away from the desired hedge

ratio as market conditions change

Static vs Dynamic Hedging

A static hedge (i.e., unchanging hedge) will avoid transaction costs, but will accumulate unwanted

currency exposures

A dynamic hedge has higher transaction costs and less currency risk exposure compared to a static

hedge Portfolio managers might need to implement a dynamic hedge by rebalancing the portfolio

periodically This hedge rebalancing will mean adjusting some combination of the size, number, and

maturities of the forward currency contracts

Refer to Example: Executing a Hedge from the curriculum

The key points are:

Hedge 1

 DC (Base) is HKD

 FC (Price) is JPY

 Short position (selling) in JPY to hedge the currency risk of a JPY-denominated asset:

 Which means a long position in HKD

 This hedge is coming due

 No special insights, so a matched swap is used:

 NOTE: Because this is a matched swap, so the mid-point of the bid/ask spread is used

 To roll over the hedge, a two-leg swap is required:

 Spot leg: Buy JPY

 At the mid-price, per convention for a matched swap

 Forward leg: Sell JPY forward:

 At mid-price adjusted for offer price forward points

 BUT, because this price is quoted in B/P, use the bid price forward points

Hedge 2

 Special insights, so a mismatched swap is used (over-hedging)

6.1.2 Roll Yield

“Rolling” is the process of closing out expiring forward contracts by buying in the spot market and

entering a new forward contract (See Exhibit 7 below)

If the forward curve is upward-sloping, the base currency is selling for a premium, so a long position will

generate a negative roll yield Conversely, if the forward curve is downward sloping, the base currency is

selling for a discount, so a long position will generate a positive roll yield

Negative roll yield

 Buying the base currency at a premium and selling at a discount (see Exhibit 7)

 Yield curve is upward-sloping (contango)

 If spot is 100 and you lock in to buy at the forward premium rate of 110

 BUT when you get to the time of settlement the rate is still 100, you have a negative roll yield

 Hedgers are usually happy to do this in order to be protected against the risk of negative

currency price movements

Positive roll yield

 Buying the base currency at a discount and selling at a premium

 This is the carry trade, so hedgers essentially pay insurance premiums to traders

Refer to Example 4 from the curriculum

The key points are:

 Investor want to hedge ZAR exposure by taking a short position in a forward contract

 ZAR is worth 0.9510 HKD in the spot market, but is priced at 0.9275 HKD in the 6-month forward

market, which is a forward discount

 Imagine investor has no views (unlike in the example) and hedges, which involves locking in a

sale price of 0.9275 HKD in six months

 This is a downward-sloping yield curve

 A trader would take the other side of this forward contract

 The trader is betting that the ZAR will not depreciate by as much as is reflected in the 6-month

forward price

 Imagine that in six months, the ZAR is trading at 0.9300 in the spot market

 The investor would have to buy ZAR at 0.9300 to deliver to the trader at 0.9275

 Note that the ZAR has depreciated relative to the HKD, but not as much as was reflected in the

6-month forward rate at the time the contract was signed

 The trader has used the earned a positive roll yield from an inverted forward curve

6.2 Currency Options

Forward contracts lock in prices, whereas options do not Options protect against losses without giving

up potential upside

In a protective put strategy we are long the underlying asset, so our upside potential is unlimited To get

downside protection we purchase a put option, this provides downside protection if the asset price

drops below the strike price

However, this insurance comes at a cost and we need to pay a premium to buy options Option

premiums are based on intrinsic value and time value

 Intrinsic value - This is the difference between spot and exercise price

 Time value – The more the time to expiration, the greater the time value

Refer to Example 5 from the curriculum

The key points are:

Question 1:

 UK-based entity with a long position in a MXN-denominated asset

 One month ago, they fully-hedged this exposure using a two-month MXN/GBP forward contract

 A is wrong because they fully-hedged the MXN10,000,000 asset (not 9,500,000)

 B is wrong because it uses the bid price (20.0500 + 0.0875 = 20.1375)

 C is correct because it uses the offer price (20.0580 + 0.0900 = 20.1480)

Question 2:

 To hedge, they sold MXN (bought GBP)

 But value of asset (in MXN) has depreciated by MXN 500,000 since then

 So, they’d need to buy 500,000 MXN

 At spot? Or at forward?

 It has to be done in the forward market

 A is wrong because they can’t do it in the spot market

 B is correct because they have to buy and they have to do it in the forward market

 C is wrong because the asset’s value has decreased in MXN, so they need to buy to reduce their

previous hedge

Question 3:

 The quote is MXN/GBP, so the peso is the price currency and the pound is the base currency

 Looking at the spot, 1-month, and two-month forward rates, the peso is depreciated versus the

pound

 When you have an upward-sloping yield curve and you are long the base currency, the roll yield

is negative

Question 4:

 Put option won’t help you take advantage of the base currency’s appreciation

 ATM call options are more expensive than OTM options

6.3 Strategies to Reduce Hedging Costs and Modify a Portfolio’s Risk Profile

Section 6.3 addresses LO.g

LO.g: Describe trading strategies used to reduce hedging costs and modify the risk–return

characteristics of a foreign-currency portfolio

To reduce risk, you have to pay a cost To reduce costs, you can pursue various strategies, but these

involve some combination of less downside protection or less upside potential Exhibit 9 gives a list of a

few popular strategies

Forward contracts Over/under-hedging Profit from market view

Option contracts OTM options Cheaper than ATM

Exotic options Knock-in/out features Reduce upside/downside exposure

Over-/Under-Hedging Using Forward Contracts

Hedging a benchmark involves taking a short position in P/B forward contracts:

 A manager with no views will hedge at the neutral rate of 100%

 A manager who believes that the base currency will depreciate will over-hedge

 A manager who believes that the base currency will appreciate will under-hedge

This is like “delta hedging” that tries to mimic the payoff function of a put option on the base currency

This adds convexity, which can be desirable in both fixed-income and currency portfolios

Protective Put Using OTC Options

Fully hedging a currency position with a protective put strategy using an at-the-money (ATM) option is

expensive because of the put premium

The cost of hedging can be reduced by accepting some downside risk Compared to a long position on an

ATM put, a long position in a 25-delta out-of-the-money (OTM) put will be cheaper, but the investor will

retain some downside risk A long position in a 10-delta OTM put will be even cheaper, but the investor

will retain even more downside risk

Risk Reversal (or Collar)

In addition to purchasing OTM options rather than ATM options, an investor can reduce the cost of

hedging can be reduced by selling (or writing) options

For example, the cost of buying a put can be offset by selling a call In this case, the downside protection

provided by the long put position is purchased at a cost of the potential upside that has been lost by

writing a short call position The corridor between the put and call strike prices is called a “collar”

Refer to Example 6 from the curriculum

The key points from Example 6 Q1 are:

 Long position in MXN-denominated asset

 To hedge this risk, the company takes a long position in a MXN/GBP forward contract

 But, any potential appreciation in the base currency is lost with a forward contract

 So, what is the best way to hedge MXN exposure while maintaining potential upside?

 Simplest strategy would be to take a long call position

 Answer A (long put) keeps upside, but a premium is paid to protect against base currency

depreciation

 Answer B (short call) is definitely wrong because appreciation will bring losses

 Answer C (long position in a 25-delta risk reversal) is a long call combined with a short

Put Spread

This is a variation of the short risk reversal position

Put spread = Protective put + short put

The long put provides downside risk protection (this is the protective put) Short put is written at a lower

strike price The premium from writing the short put offsets the cost of buying the long put The

downside risk is reduced, but is limited to the difference between the two strike prices

The key points from Example 6, Q2 are:

 Long ATM call option, which reduces cost most?

 A is wrong, because it involves buying (i.e., spending more money)

 B is wrong, because a 10-delta call is further OTM than a 25-delta call and will get less money

 C is right because writing a 25-delta call will bring in more premiums than writing a 25-delta call

Seagull Spread

Seagull spread = Put spread + short call

Thus a short Seagull spread has:

 Long ATM put (ATM is affordable because two premiums are earned)

 Short put (lower strike)

 Short call (higher strike)

The two short positions provide the “wings” and the long position provides the “body”

Note that two premiums are earned (short put and short call) and short call gives away upside beyond

the risk exposures desired by the client and provide them at the lowest possible price.”

Two most common exotic options are:

1 Knock-in/Knock-out

2 Digital options

A plain vanilla option can be modified to only be in effect at certain price levels The option comes into

effect (knocks-in) when the price of the underlying reaches a certain level (the “trigger price”), and

ceases to be in effect (knocks-out) when the price of the underlying reaches another level Note that the

trigger prices are not the same as the option’s strike price These are more restrictive than vanilla

options and therefore cost less

Digital options (aka binary options or all-or-nothing options) pay off a fixed amount if they touch their

exercise price before expiry These provided “highly leveraged exposure to movements in the spot rate”,

so they are better suited to active currency management rather than hedging They are used to express

directional views and provide extreme payoffs, so they cost more than vanilla options with the same

strike price

Section Summary

a Identify the base currency Derivatives are quoted in terms of buying or selling the base currency

b Does the base currency need to be bought or sold?

c If buying, use a combination of long call and/or long forward contract This cost can be reduced by

either buying an OTM call option or writing options to earn premiums

d If selling the base currency, use a combination of long put and/or short forward contract This cost

can be reduced by buying an OTM put option or writing options to earn premiums

e The higher the allowed discretion for active management, the lower the risk aversion

f Using varying strike prices can reduce hedging costs

6.4 Hedging Multiple Foreign Currencies

Section 6.4 addresses LO.h

LO.h: Describe the use of cross-hedges, macro-hedges, and minimum-variance-hedge ratios in

portfolios exposed to multiple foreign currencies

When hedging the risk of exposure to multiple currencies, the tools are similar to those discussed above,

but the manager must be aware of the correlations between all combinations or currencies Also,

offsetting positions in currencies that are highly correlated (e.g., Australia and NZ), can have a netting

effect and hedging may not be necessary

Cross-Hedges and Macro Hedges

A cross hedge (proxy hedge) occurs when a position in one asset (or a derivative based on the asset) is

used to hedge the risk exposures of a different asset

Cross hedges are referred to as macro hedges when the hedge is focused on the entire portfolio Macro

hedging strategies can include:

 Gold

 Volatility overlay

 Derivatives based on fixed-weight baskets of currencies

It is likely inefficient to hedge each currency exposure separately

Refer to Example 7 from the curriculum

Minimum Variance Hedge Ratio

This is a mathematical regression oriented technique for coming up with the hedge ratio We run a

regression where the dependent variable is the change in value of the asset (in terms of domestic

currency) and the independent variable is the change in value of the hedging instrument The objective

of the regression is to minimize the variance of the error term and to minimize the tracking error This

exercise helps us come up with the optimal hedge ratio

Basis Risk

Basis risk exists when an indirect hedge is used instead of a direct hedge The asset being hedged is not

perfectly correlated with the proxy that is being used to hedge it

6.5 Basic Intuitions for Using Currency Management Tools

1 The portfolio has long exposure to the base currency, so it has to be offset with a short position

in derivatives such as a forward contract and/or options

2 Hedging currency risk is not free – there will be either a direct or implicit cost

3 The cost of a given hedge structure will vary depending on market conditions

4 Hedging costs can be reduced

5 Reducing hedging cost comes with some combination of more downside risk and/or less upside

potential

6 Cross-hedges bring basis risk

7 There is no best way to hedge currency risk

Refer to Example 8 from the curriculum

7 Currency Management for Emerging Market Currencies

7.1 Special Considerations in Managing Emerging Market Currency Exposures

This section addresses LO.i:

LO.i: Discuss challenges for managing emerging market currency exposures

There are two core special considerations in managing emerging market currency exposures:

 They generally have higher trading costs as compared to the major currencies even during

“normal” market conditions

 There is an increased likelihood of extreme market events and severe illiquidity under stressed

market conditions For example, Asian currency crisis

7.2 Non-Deliverable Forwards

Some emerging markets impose capital control restrictions In such cases, we use non-deliverable

forward contracts