Formulating a currency management program — MCQs

Meridian Global Fund reports performance in USD but invests in securities denominated in several foreign currencies. Its currency manager, Daniel Cho, treats the market value of each foreign asset as a long exposure to the asset's currency unless an offsetting hedge is in place. Exchange rates are quoted as units of USD per unit of foreign currency, so an increase in the USD-per-EUR rate represents euro appreciation against the dollar. The fund owns the Eurozone equity position shown in Exhibit 1. The investment committee expects the underlying equities to perform well but is concerned that euro depreciation could reduce their USD value over the next six months. The committee wants downside currency protection but also wants to retain gains if the euro appreciates. Cho is therefore comparing an outright forward hedge with a European currency option. The option expires at the end of the six-month hedge horizon and can be exercised only at expiration. Cho also calculates the no-arbitrage six-month forward exchange rate using covered interest parity. Both interest rates in Exhibit 1 are continuously compounded annual rates. USD is the price currency and EUR is the base currency. There are no transaction costs, taxes, capital controls, or credit constraints. Cho notes that using the interest-rate differential in the wrong direction would incorrectly predict the direction of the forward points. Because the put premium is material, the committee asks Cho to consider a collar. The committee is willing to surrender currency gains above a specified upper exchange rate in exchange for reducing the net option premium, but it will not accept additional downside exposure below the put exercise price. The options used in the collar would have the same notional principal and expiration date but different exercise prices. Meridian also expects to receive GBP from a security sale in three months. The amount and timing are contractually fixed, but the USD value is uncertain. Cho intends to use a three-month deliverable forward matched to the receipt. The hedge objective is to lock in the USD value of the GBP receivable rather than speculate on the future direction of GBP.

NorthBridge Global Fund reports performance in USD but invests in securities and receives cash flows denominated in multiple currencies. Currency manager Priya Shah is reviewing the fund's EUR exposure. Exchange rates are quoted as units of USD, the price currency, per one unit of EUR, the base currency. An increase in the quoted rate therefore represents appreciation of EUR against USD. The fund owns an unhedged EUR-denominated equity portfolio and expects a separate EUR receivable in six months. The receivable is contractually fixed and has no credit uncertainty. Shah's immediate objective for the receivable is to remove the effect of EUR depreciation on its USD value. Because the fund will receive EUR in the future, it is economically long EUR before any hedge is established. Shah can transact at the spot and forward rates implied by the market data in Exhibit 1, with no transaction costs or counterparty default. The six-month interest rates in Exhibit 1 are annualized simple rates and apply for exactly one-half of a year. Shah uses covered interest parity for a USD-per-EUR quotation. Accordingly, the USD interest accumulation factor is associated with the price currency and the EUR accumulation factor with the base currency. She also considers whether a fixed forward conversion is consistent with the fund's objectives. The investment committee subsequently modifies the objective for the receivable. It wants to establish a minimum USD conversion value but retain any benefit if EUR appreciates against USD. The committee is willing to pay an upfront option premium. All currency options under consideration are European and expire when the receivable is collected. A put on EUR with an exercise rate quoted in USD per EUR provides the right to sell EUR and receive USD at the exercise rate. Finally, a dealer proposes a currency swap under which NorthBridge would receive EUR-denominated payments and make USD-denominated payments. The proposal applies to the existing EUR equity portfolio but does not transfer ownership of the equities or alter their local-market returns. Shah must determine whether those swap cash flows offset or reinforce the portfolio's existing currency exposure. Exhibit 1 reports the relevant exposure and market data, and Exhibit 2 lists the available transactions.

Meridian Manufacturing has both interest-rate and foreign-currency exposures. Its treasury committee is considering derivatives that match the timing and economic direction of those exposures. All rates and discount factors are free of credit risk, and transaction costs, collateral effects, and taxes are ignored. Meridian recently issued floating-rate debt and wants greater certainty regarding interest expense. It therefore enters a three-year pay-fixed, receive-floating interest rate swap with annual settlements and a notional principal of USD 40 million. The floating leg resets to the relevant one-year reference rate at the beginning of each annual period. At initiation, the fixed rate must make the swap's value zero. The committee instructs the treasury analyst to derive that rate from the discount factors in Exhibit 1 rather than approximate it using an arithmetic average of spot rates. The treasurer also wants to understand the swap's value after initiation. A pay-fixed swap can be viewed as a position that benefits when the contractual fixed rate becomes lower than the fixed rate available on a comparable new swap. The committee considers an immediate parallel increase in market swap rates, with no change in Meridian's credit quality or contractual terms. Separately, Meridian expects to receive EUR 12 million from a European customer in one year. Meridian reports performance in USD and has no offsetting EUR liability. Its concern is that the USD value of the receivable could decline before payment. The company seeks to eliminate this exchange-rate uncertainty rather than retain favorable currency upside. The contemplated currency forward will mature on the receivable's payment date and will exchange the full EUR principal for USD. Currency quotations in Exhibit 1 use the EUR/USD convention, expressed as USD per EUR. EUR is therefore the base currency and USD is the price currency. Under covered interest parity, the forward rate reflects the relative growth rates of the price currency and base currency. The analyst must avoid reversing the quotation or treating the interest-rate differential as a simple number of forward points without reference to the spot rate. Both currency interest rates are annual effective rates for the one-year horizon.

Northport Endowment uses derivatives to alter portfolio exposures without immediately trading the underlying securities. Chief investment officer Marcus Lee asks a risk analyst to assess an interest rate swap, an equity-index futures overlay, and a commodity cross-hedge. Transaction costs, taxes, bid–ask spreads, and default losses are ignored in all numerical calculations. One year ago, the endowment entered a receive-fixed, pay-floating interest rate swap with annual settlements. The swap was priced at zero value at initiation. A floating-rate reset has just occurred, and only one annual settlement remains. Therefore, the floating-rate side is valued at par immediately after the reset. The fixed side is valued using the current one-year discount rate. Lee notes that the swap's notional principal is not exchanged, although representing each side as a bond remains a valid valuation framework because the offsetting principal amounts cancel. The endowment also owns a diversified equity portfolio benchmarked to the same broad index underlying an exchange-traded futures contract. Lee expects elevated short-term equity volatility and wants to reduce, but not eliminate, systematic equity exposure for three months. The portfolio value and beta are expected to remain stable while the hedge is established. The analyst is instructed to calculate the number of contracts from the desired change in beta, portfolio value, and current futures contract value. A short futures position is required when the target beta is below the current beta. Lee also asks the analyst to compare this futures-based approach with an alternative equity total return swap, which delivers an effective beta exposure of 1.0 per dollar of notional and therefore requires no futures price or contract multiplier in its sizing calculation. For a commodity allocation, the endowment cannot find a liquid futures contract written on the exact commodity held. It therefore considers a cross-hedge using a related futures contract. Exhibit 3 reports the standard deviations of changes in the spot and futures prices and their correlation. The minimum-variance hedge ratio is defined as the correlation multiplied by the ratio of spot-price volatility to futures-price volatility. The endowment is long the spot exposure and will sell futures to offset adverse price declines. Finally, Lee compares exchange-traded futures with bilateral forward contracts. Futures are standardized, cleared, and marked to market daily. These features generally reduce the buildup of bilateral counterparty credit exposure. They do not guarantee a perfect hedge because contract terms may fail to match the exposure, and daily variation-margin payments can produce material interim liquidity needs even when the hedge is expected to be effective over its full horizon.