Currency Risk Management

CURRENCY RISK MANAGEMENT

The most important area of risk management in international investments is _________ fluctuations.

The purpose of a currency hedge:

I. Hedging Strategies
*Which Instrument Should Be Used To Hedge Currency Risk?

1. First determine how risky the underlying currency is by analyzing past ___

2. If the standard deviation is high (____ % or more) ____ then use ____ to hedge because

3. If the standard deviation is low (less than 20%) then use ______contracts to hedge.

4. Only use __________ contracts and ________ agreements when the firm wants to accept ________ of the underlying asset. In this case, forwards may be more efficient than either options or futures.

5. ________ and _____ hedges perform best when the time horizon to be ______ (i.e. more than _____ year).

How Many Contracts Should Be Bought or Sold?

1. Use the following rules of thumb to first determine whether to enter the market as a buyer or a seller (REM: In order to profit, the investor always wants to buy ____ and sell _____

Assume: The firm has an existing long position

in a foreign currency. The firm wants to hedge

against a __________ of the foreign currency.

The firm could:

a. ________ call Options on the foreign currency

b. ________ put options on the foreign currency

c. ________ forwards or futures contracts on the currency

Assume: The firm has an existing short position

in a foreign currency (this could imply that they

are either anticipating the need to purchase foreign

currency at a later date or they have sold currency

that they do not yet own). The firm wants to hedge

against a(n)___________- of the foreign currency.

The firm could:

a. ________ call Options on the foreign currency

b. ________ put options on the foreign currency

c. ________ forwards or futures contracts on the currency

2. To determine the number of contracts which should be bought or sold in currency options the use of ________ hedging techniques is common. Less commonly used are the 'gamma' hedges, 'rho' hedges and 'theta' hedges.

3. To determine the number of futures or forward contracts which should be bought or sold use one of the following hedging techniques:

naive hedge

regression hedge

duration hedge

refined duration hedge

basis point valuation model

Which Exercise Price and Expiration/Delivery Should be Chosen?

1. Futures and forwards have no _______ so the firm need only focus on which _____ date is needed once it is clear that futures or forwards is the desired hedging instrument _______ term futures contracts mimic the behavior of the _______ exchange rate better and are thus _______ risky. Near term contracts also have greater _______ and thus offer more liquidity. For longer term (still ______ than one year) hedging needs the manager can:

a. Trade short-term contracts and _____ them ______ just prior to delivery or

b. Trade contracts which have a scheduled delivery whict the expected hedge period.

2. Option trading requires that the firm's management select both a desired ________ and expiration date. As with futures, near term contracts in options behave much the same way thus the firm's management faces essentially the same decision as outlined above.

In selecting an exercise price for option trading it is helpful to note the following: At-the-money exercise prices (FX ___ E) are _____ and more ______ if the firm is entering as a buyer, the at-the-money contract is likely to be the best choice. If the firm is entering as a seller the small premium may make the closest to at-the-money unattractive. The risk of choosing in-the-money options (FX ___E) versus the

premium received must be balanced.

How to Hedge Off-Market Currencies?

Remember that options, futures and forwards trade only on the currencies of _____ industrial nations (i.e. ____ currencies) investors needing to hedge other currencies (i.e. _____ market currencies) should devise one of the following strategies:

1. ______ hedge by trading in a currency contract which is closely

correlated to the movements of the off-market currency.

2. Arrange a _____ transaction with a _____ bank.

3. Enter the _______ market for options and forwards.

II. Rates of Return on Hedged Portfolios

Let:

V_f,t = the value of the foreign assets at time t measured in the same foreign currency;

V_f = the value of the foreign assets at the beginning of the period measured in the same foreign currency;

R_f = the rate of return on a portfolio of foreign assets measured in the same foreign currency;

R_f,d = the rate of return on a portfolio of foreign assets measured in the domestic currency;

S_t = the exchange rate at time t between a domestic and foreign currency;

S_o = the exchange rate at the beginning of the period between a domestic and foreign currency;

s_t = the rate of change in the exchange rate between the domestic and foreign currency (D/F) from t=0 to t;

F_b= the buy price per unit of foreign currency in the futures market;

F_s = the sell price per unit of foreign currency in the futures market;

f_t = the rate of change in the futures price during the holding period (NOTE: not a rate of return);

h = the optimal number of derivative securities needed to hedge the optimal hedge ratio;

Note the following relationships:

R_f =(V_f,t – V_f,o)/V_f,o

S_t = (S_t- S_o)/S_o

f_t = [(F_s - F_b) h]/[F_bx h]

R_f,d = [(V_f,t x S_t ) + (V_f,o x S_o)]/(V_f,o x S_o)

Assume that a U.S. investor has invested 1 million in British gilts. Since the investor is long in the bonds, to hedge he could sell 1 million sterling worth of $ equivalent currency futures contracts. The investor decides to use a naive approach and sells 40 currency futures (i.e. l million BP/125,000BP).

t=0 Sell 40 Jun futures for 1.423 $/BP

Cash rate = 1.473 $/BP

t=1 Buy 40 Jun futures for 1.323 $/BP. Cash rate

1.373 $/BP Cash value of bonds = 1.010 mill. BP

Questions:

(a) What is the rate of return on the investor's cash portfolio in dollar terms?

(b) Show how the above rate of return was earned i.e. which portion of the return can be contributed to currency movement, spot bond position?