30 RELATE TO ASSET ALLOCATION, GLOBAL BONDS, RISK MANAGEM...

Questions 25-30 relate to Asset Allocation, Global Bonds, Risk Management, and Risk

Management Applications of Derivatives.

Mary Rolle and Betty Sims are portfolio managers for RS Global Investments, located in

Toronto, Canada. RS specializes in seeking undervalued stocks and bonds throughout the

North American, Asian, and European markets. RS has clients throughout North America,

however, the majority are Canadian (CAD) institutional investors. RS has traditionally

managed currency risk in their portfolios by assigning it to their portfolio managers. The

manager is allowed discretion for hedging currency risk within the confines of the investor's

investment policy statement with the primary goal of reducing portfolio risk.

Rolle and Sims are currently deciding whether to hedge the currency risk of a portfolio of

Japanese (JPY) stocks. Rolle explores the possibility of using three different currency hedges.

Each is an option contract on the yen-Canadian dollar exchange rate.

Hedge A Buy CAD Calls

Hedge B Sell CAD Puts

Hedge C Sell JPY Puts

RS has a portfolio of European stocks and would like to change its equity risk. They can enter

into futures contracts on the Eurostoxx index of large European stocks. The information

below provides the characteristics of the futures contract and the portfolio.

Portfolio value in euros 2,000,000

Desired beta value 1.80

Current portfolio beta 0.60

Beta of futures contract 1.02

Value of one futures contract in euros 110,000

Risk-free rate 2.5%

RS is also invested in British and Argentine stocks. RS has taken a position in two main

sectors of the British economy. The first sector consists of manufacturers who derive a great

deal of their business from exporting to the United States and Canada. The other sector

consists of British service firms who are largely immune from international competition,

because most of their business is localized and cannot be provided by foreign firms. The main

investment in the Argentine stocks consists of firms who provide cellular phone service to

Argentine consumers. Rolle and Sims discuss which currency positions RS should hedge.

Upon further analysis, RS has determined it will hedge the currency risk of the Argentine

stocks. Their goal is downside protection and modest upside potential for the ARS currency.

RS has also received notification from one of its larger clients that a large contribution will be

received into the portfolio in six months; the funds are to be synthetically preinvested in a

60/40 allocation to U.K. stocks and bonds.

...

Which of following best describes the approach used by RS to manage currency risk?

A) Currency overlay.

B) Discretionary hedging.

C) Active currency management.

Explanation

An overlay involves the use of a third party to manage the currency risk. Active currency

management places greater emphasis on increasing return through currency management,

while discretionary puts more emphasis on risk reduction; RS's goal is risk reduction.

For Further Reference:

Study Session 9, LOS 19.b

SchweserNotes: Book 3 p.170

CFA Program Curriculum: Vol.3 p.387

Question #26 of 60

Regarding hedging the currency risk of the Japanese stock portfolio, which hedge would

be most appropriate?

A) Hedge A.

B) Hedge B.

C) Hedge C.

RS is a Canadian firm with long currency exposure to the JPY. Using currency options to

reduce downside currency exposure RS would buy puts on the JPY (equivalent to buying

calls on the CAD).

Study Session 9, LOS 19.g

SchweserNotes: Book 3 p.186

CFA Program Curriculum: Vol.3 p.420

Question #27 of 60

For RS to change the equity risk of their European stocks, the most appropriate strategy is to:

A) buy 4 equity futures contracts.

B) buy 18 equity futures contracts.

C) buy 21 equity futures contracts.

Study Session 15, LOS 28.a

SchweserNotes: Book 4 p.138

CFA Program Curriculum: Vol.5 p.227

Question #28 of 60

Regarding the currency hedge of the British and Argentine stocks, which of the following

would RS least likely hedge?

A) The British service firms.

B) The British manufacturers.

C) The Argentine cellular phone service firms.

The question deals with the impact of correlation between local market and local currency

return. Positive correlation increases volatility of domestic return to an investor in a foreign

market, increasing the minimum variance hedge ratio and the need to hedge currency risk.

Negative correlation has the opposite effect. The question describes investment in British

manufacturers as having negative correlation. A decrease in the GBP increases exports,

revenue, profits, stock prices, and local market returns. This negative correlation between

local currency and local market returns lowers the volatility of domestic returns to a non-

British investor in British manufacturers. Neither the British service firms nor Argentinean

cell service providers show any correlation (a correlation of 0.0) between local market and

local currency returns.

Study Session 9, LOS 19.f

SchweserNotes: Book 3 p.180

CFA Program Curriculum: Vol.3 p.409

Question #29 of 60

To meet its currency risk management goals for the ARS, RS is most likely to:

A) sell the ARS forward to buy CAD.

B) buy 40-delta and sell 30-delta puts on the ARS.

C) buy out-of-the-money calls on the CAD and sell out-of-the-money calls on ARS.

RS has described a collar on the ARS. A collar will provide downside protection if the ARS

declines to a strike price below the current exchange rate and retain upside potential until the

ARS appreciates to a strike price above the current exchange rate. A collar is created by

purchase of an OTM put on the ARS (equivalent to an OTM call on the CAD) and sale of an

OTM call on the ARS (equivalent to an OTM put on the CAD). The other answer choices are

incorrect. The purchase of 40-delta and sale of 30-delta puts are a put spread that provides

downside protection below one strike price but no further protection if the ARS falls below a

lower strike price. The forward would remove all upside and downside exposure.

Question #30 of 60

Which of the following strategies is most compatible with RS's requirement to preinvest

funds in a 60/40 allocation to U.K. stocks and bonds?

A) Buy U.K. FTSE stock index futures and sell U.K. bonds futures.

B) Buy calls and sell puts on U.K. stock index futures, plus buy calls on U.K. bonds.

C) Buy calls and sell puts on U.K. stock index futures, plus sell calls and buy puts on U.K. bonds.

The most straightforward strategy to preinvest is to buy futures (or forwards) on U.K. stocks

and bonds. Buying ATM calls and selling puts on U.K. stock indexes or futures is equivalent

to buying a future or forward on U.K. stocks, thus all three answers meet the objective of

preinvesting in U.K. stocks. The issue becomes which answer best replicates the purchase of

U.K. bonds. Selling U.K. bond futures is exactly wrong. Selling the calls and buying puts

replicates an incorrect short position in U.K. bonds. Buying the calls would give the upside,

but not downside, risk of U.K. bonds. This best replicates the purpose of preinvesting,

capturing the upside of the asset.

Study Session 15, LOS 28.d, e

SchweserNotes: Book 4, p.148, 151

CFA Program Curriculum: Vol.5 p.241, 245

Study Session 15, LOS 29.a, b

SchweserNotes: Book 4, p.170, 175

CFA Program Curriculum: Vol.5 p.286, 293

Question #31 of 60