Reference no: EM131070009

Currency Risk Management

1. A Japanese investor holds a portfolio of British stocks worth £10 million. The current threemonth dollar/pound forward exchange rate is £:$ = 1.65, and the current three-month dollar:yen forward exchange rate is $:¥ = 100. What position should the Japanese investor take to hedge the yen:pound exchange risk?

2. An Italian investor owns a portfolio of South Korean stocks worth 1.25 billion won. The current spot and one-month forward exchange rates are €:won = 1,250 (one won = 0.0008 euro). Interest rates are equal in both countries. You are worried that some rumour about the bankruptcy of a major local bank could lead to a strong depreciation of the won. You have observed that Korean stocks tend to react negatively to a depreciation of the local currency (won). A broker tells you that a regression of Korean stock returns (measured in won) on the won:€ percentage exchange rate movements has a slope of +0.50. In other words, Korean stocks
tend to go down by 0.5% when the won depreciates by 1%.

(a) Discuss what your currency hedge ratio should be.

(b) A month later, your Korean stock portfolio has gone down to 1.1875 billion won and the spot and forward exchange rates are now won:€ = 0.00072. Analyse the return on your hedged portfolio.

3. An American investor believes that the dollar will depreciate and buys one call option on the euro at an exercise price of 110 cents per euro. The option premium is 1 cent per euro, or $625 per contract of 62,500 euros (Philadelphia):

(a) For what range of exchange rates should the investor exercise the call option at expiration?

(b) For what range of exchange rates will the investor realise a net profit, taking the original cost into account?

(c) If the investor had purchased a put with the same exercise price and premium, instead of a call, how would you answer the previous two questions?

4. An American investor is considering using options to hedge his portfolio value in the UK. The premium on put options with a strike price of $2/£ is $0.06/£ when the exchange rate is $2/£. The associated delta is -0.4:

(a) How many puts should he hold to hedge a £500,000 portfolio value?

(b) How would your answer change if he is instead interested in using put options with a strike price of $1.95/£?

5. An Italian importer will be paid $1 million in three months (March). He must decide whether to sell $1 million forward or to buy currency options for that amount. The current market prices are as follows:

Exchange rates: Spot €:$ = 1.10
3-month forward: €:$ = 1.11
Call euro March 110 U.S. cents: 1.5 U.S. cents per €
Put euro March 110 U.S. cents: 1.0 U.S. cents per €

What are the differences between the strategies of selling currency forward and buying currency options?