42 RELATE TO ASSET ALLOCATION AND RISK MANAGEMENT APPLICA...

Questions 37-42 relate to Asset Allocation and Risk Management Applications of

Derivatives.

International Opportunity Investors (IOI) manages EUR-denominated equity portfolios for

U.S.-based investors. Cindy Amsler is one client and has a well-diversified portfolio that is

similar to the local index portfolio in capitalization weightings.

Theresa Aims is the senior portfolio manager overseeing Amsler's account. Aims has recently

hired two associate managers to join her team. Both have passed the Level II CFA exams and

will be studying for the Level III exam. Aims has a bit of a sense of humor (at least that is

how she sees it) and decides to quiz her new associates and see how much they really know.

She says the following.

1. "Investing is risky. If we invest in foreign equity, there is no way to eliminate all the risk.

Prove me wrong."

2. "Assuming we can set up a perfect currency hedge, we will earn only the local stock

market return."

3. "Another possibility for our foreign currency exposure is to limit the currency loss and

gain to 3%. But the net option premium is too high. We'll need an additional option

position to reduce the premium. We can do that by assuming the currency won't change

by more than 10% in value."

Fortunately, the associates pass Aims' test and she moves on to current portfolio issues.

Aims uses discretionary active hedging of the euro equity markets and/or currency in

Amsler's portfolio when her indicators suggest risk is unusually high. She has her associates

compile data on the Eurostoxx equity index futures contract. They also regress returns of the

futures contract with Amsler's portfolio and verify there is a high correlation. Then, they

collect current account information. Amsler's equity portfolio has a market value of

EUR15,000,000 and a beta of 1.15 relative to the local underlying index.

Then they collect data in Exhibit 1.

Exhibit 1: Selected U.S. and Europe Market Data

Spot U.S. dollar/euro exchange rate $1.05

One-year risk-free rate in Europe 2%

One-year risk-free rate in the United States 4%

Price of 1-year futures contract on the Eurostoxx equity index €120,000

Beta of futures contract, relative to the local underlying index 0.975

Forecasted return of the local underlying index (beta of 1.00) over one year −12%

Forecasted spot USD/EUR exchange rate in one year $1.12

Aims also has them perform several return and hedging calculations.

...

Regarding item 1, which of the following will the associates recommend to eliminate all the

currency risk of investing in the euro-denominated stocks for the U.S. investors?

A) Sell the USD forward.

B) Buy 40-delta puts on the EUR.

C) Buy ATM puts on the EUR and sell ATM puts on the USD.

Question #38 of 60

Base on Exhibit 1, which of the following is most correct regarding Aim's item 2?

A) With a perfect currency hedge we can earn exactly zero on the currency.

B) A perfect currency hedge is not possible in that situation.

C) We can't be sure but will lose about 2% (a -2% return) on the currency contracts used for the

currency hedge.

Question #39 of 60

Regarding item 3, the associates will recommend:

A) buy puts and sell calls on the EUR that are 3% out-of-the-money.

B) buy puts and sell calls on the EUR that are 3% out-of-the-money, plus sell further out-of-the-

money calls on the EUR.

C) buy puts on the EUR that are 6% out-of-the-money and sell calls on the EUR that are 3% out-of-

the-money.

Question #40 of 60

Based on Exhibit 1, which of the following is closest to the dollar return on the Amsler's

unhedged equity portfolio. (Neither equity nor currency risk is hedged.)

A) An 8% loss.

B) A 12% loss.

C) A 7% gain.

Question #41 of 60

Based on Exhibit 1, assuming the equity is hedged and the currency is not hedged, which of

the following is closest to the dollar return on Amsler's equity portfolio?

A) A 9% gain.

B) An 11% gain.

C) A 7% loss.

Question #42 of 60

The contract position to hedge the equity risk in Amsler's portfolio is:

A) sell 125 contracts.

B) sell 147 contracts.

C) no precise calculation can be made unless the currency is also hedged.

Question #43 of 60