TO 18 RELATE TO ASSET ALLOCATION PATRICK SMITH CASE SCENA...

Questions 13 to 18 relate to Asset Allocation

Patrick Smith Case Scenario

Patrick Smith is a currency overlay manager at East End Advisors (EEA), a U.K. based

wealth management firm. EEA runs a global equity fund which is invested in domestic as

well as US, French, South African, Russian, and Brazilian equities. The exposures to the

emerging market foreign currencies are currently unhedged and Smith has been tasked

with devising a suitable hedging strategy.

Two months earlier, Smith hedged EEA’s exposure to the USD and EUR using four-

month forward currency contracts. Smith has always preferred forward over futures

contracts for hedging currency exposures and justifies his choice as follows:

Justification 1: “Forward contracts are especially useful for hedging currency exposures

of emerging market currencies for which there is a general lack of liquid

futures.”

Justification 2: “Forwards contracts have higher liquidity and lower credit risk when

traded in larger quantities.”

Justification 3: “There are no initial and maintenance margins associated with forward

contracts and so the volatility of the organization’s cash flows will be

relatively low when opting for this hedging instrument.”

Smith begins his assignment by hedging EEA’s Russian ruble (RUB) 3.0 million

investment using a three-month currency forward contract at an agreed upon rate of

RUB/GBP 85.45. Two months later, the value of the position and spot rate declines to

RUB 2.2 million and RUB/GBP 81.05 respectively. Smith has decided to rebalance the

position using an FX swap.

Next, Smith turns his attention towards EEA’s BRL 10 million and ZAR 5 million

foreign currency exposures. He enters into a discussion with a senior equity manager at

the firm in which he shares his intention to employ the same hedging strategy for the two

currencies. He shares details concerning potential hedging strategies with the equity

manager while making the following statement:

“I am deciding between i) fully (and dynamically) hedging the currency exposures and ii)

employing a strategy to reduce hedging costs by accepting some downside risks and

upside potential. The second strategy would enable me to express market views

concerning the GBP/BRL and GBP/ZAR. My investment horizon will be three months.”

Smith proceeds to evaluate whether the first strategy will be worthwhile based on spot

and forward rate data collected (Exhibit).

Exhibit:

Data for Evaluating a Fully Hedged Currency Position

Three-Month Mid-

Mid-Market

Three-month

Market Forecast

Current Spot Rate

Forward Points

Spot Rate

GBP/BRL 4.6500 -120/-110 4.2511

GBP/ZAR 17.6385 135/145 17.0580

Smith concludes his assignment by evaluating 3-month BRL- and ZAR-denominated

currency options. Based on his spot rate expectations, he is aiming to design a strategy

which will generate limited upside potential on EEA’s exposures while providing

downside risk protection.

13. With respect to his preference for forward contracts over futures, Smith is most

accurate regarding Justification:

A. 1.

B. 2.

C. 3.

14. To rebalance the hedge, Smith is required to:

A. buy RUB 0.8 million today.

B. sell 0.01 million GBP today.

C. buy RUB 0.8 million two months from today.

15. Based on Smith’s conversation with the senior equity manager, his emerging

market currency risk management decision involves choosing between:

A. passive and active currency management.

B. active and discretionary currency management.

C. passive and discretionary currency management.

16. Using the data in the Exhibit, Smith will hedge its exposure to:

A. BRL only.

B. ZAR only.

C. both BRL and ZAR.

17. Using the data in the Exhibit, which of the following currency pairs would be

expected to have a positive roll yield?

A. GBP/BRL only.

B. GBP/ZAR only.

C. Both currency pairs

18. Which of the following methods will allow Smith to gain the most upside and

allow for a reduction in costs for the hedge on EEA’s FX exposures using

currency options?

A. Long ATM puts

B. Long 10-delta puts

C. Short position in a 25-delta risk reversal