“CURRENCY RISK MANAGEMENT” THE CANDIDATE SHOULD BE ABLE TO

46. “Currency Risk Management” The candidate should be able to: a) demonstrate and explain the use of foreign exchange futures to hedge the currency exposure associated with the principal value of a foreign investment; 2008 Level III Guideline Answers Morning Session – Page 38 of 40 Question: 11 Topic: Portfolio Management – Global Context Minutes: 9 Guideline Answer: PART A • The Tanaka fund value decreases when the Yen strengthens. In order to fully hedge the currency exchange rate moves, the manager must sell dollar futures contracts and sell euro futures contracts. • The appropriate number of contracts required to fully hedge exchange rate risk is a function of the principal value being hedged and the futures contract size. A full hedge would require $900,000,000/$100,000 = 9,000 dollar contracts and €700,000,000/€100,000 = 7,000 euro contracts. PART B The international return $945/$900 -1 = 5% Dollar Return €735/€700 -1 = 5% Euro Return The unhedged return in Yen Return on the unhedged portfolio in Yen (¥ millions) Date Dollar Investments Euro Investments Total Portfolio ¥109,025 1 July 2008 ¥104,310 ($900 x 115.90) (€700 x 155.75) ¥213,333 ¥106,391.25 1 September 2008 ¥104,800.50 ($945 x 110.90) (€735 x 144.75) ¥211,191.75 Profit / (Loss) ¥490.50 (¥2,633.75) (¥2,141.25) 0.47% -2.42% -1.00% (¥2,141.25) / ¥213,333 = -1.00% or a 1% loss Morning Session – Page 39 of 40 The hedged return Futures returns in Yen (¥ millions): Yen Gain/(Loss) on $ futures = (115.70 - 110.77) x 900 = 4.93 x 900 = ¥ 4,437 Yen Gain/(Loss) on € futures = (156.70 - 144.80) x 700 = 11.90 x 700 = ¥ 8,330 Hedged Yen return = Unhedged Yen return + Futures returns in Yen (¥ millions) Return on the hedged portfolio in Yen (¥ millions) Dollar Investments Euro Investments Total Portfolio Unhedged Return ¥490.50 (¥2,633.75) (¥2,141.25) Futures Return ¥4,437.00 ¥8,330.00 ¥12,767.00 ¥4,927.50 ¥5,696.25 ¥10,625.75 Profit / (Loss)