Currency Hedge Question?

CFA Level III Derivatives
#1

A trader has a EUR 5,000,000 short asset exposure and wishes to hedge it using a six-month long forward contract. Relative to choosing a one-month long forward contract that is rolled over each month, the six-month forward contract would most likely :

A)have some realized gains or losses prior to forward maturity.

Failed

B)indicate lower risk aversion.

Achieved

C) be a perfect hedge of the initial notional value.

Explanation

The six-month forward contract requires no rebalancing, while the one-month rolled forward requires monthly rebalancing. Less frequent rebalancing indicates lower risk aversion.

Because the value of the hedged asset could change over the six months, the six-month hedge is not perfect and could result in a significantly over- or underhedged position (for example, if the asset value increases to EUR 5,500,000 in two months, the manager would be underhedged by EUR 500,000).

Because there are no contracts to roll over prior to the six-month maturity, there are no realized gains or losses generated before the maturity of the six-month contract.

I was confused on this one…

If looking to hedge for 6 months, why would rebalancing monthly be more risk averse??
Also, why wouldn’t the 6 month contract not be a perfect hedge on the initial notional value??? I get the value will change over time, but it specifcically says the initial notional value, which my understanding is that it WILL be perfectly hedged??

Thanks!

#2

I think the rebalancing frequency is linked to the point around the gap between the hedged position and the asset, so hopefully the below explains both:

I infer from the question that this is a currency-related hedge to remove short exposure to the Euro valued at €5m today, with a six-month horizon (i.e. they will need €5m in six months time; perhaps they will need to buy back Euro-denominated stocks that they have shorted). So you could enter into a hedge to buy €5m in six months’ time to offset that currency exposure (i.e. in six months, you are simultaneously receiving the Euros from the hedge and spending them on the share purchase). But if, in the meantime, the underlying position changes (let’s say the shares go up so the short position gets larger/need for more Euros in future), the amount you’ve originally hedged (€5m) and the amount you’re exposed (say, €5.5m if the share price increases by 10%) become mismatched, so you could end up under-hedged.