Curriculum Volume 5 P.292 Q22.

CFA Level III Derivatives
#1

The question states that the person sold SEK/EUR futures to hedge EUR-denominated asset, and now there is higher forward premium for SEK/EUR rate. What will the hedge position experience?

The answer is higher roll yield.

Let us say the person sold SEK/EUR when 1 SEK = 1 EUR, so the person agrees to sell 1 EUR and receive 1 SEK. Now the forward permium is higher (ie. 2 SEK = 1 EUR), should not the person loss money (lower roll yield) because could have get more SEK?

Can someone explain to me, thanks?

#2

Roll yield is positive because the person SOLD the future. If they were long, they would have negative roll yield due to the forward premium. Short forward premium = + roll yield.

#3

I am still not understanding why.

The person sold the futures (sold the base currency), and then the base currency appreciates.

If sold something appreciated before it appreciate, isn’t it implied a loss?

If possible, please provide an example, thanks.

#4

If the market is at a forward premium (i.e. F>S) the yield curve is upward sloping.

You are short the Forward (base currency = Euro) and it rolls back (converges) towards the spot creating a positive roll yield.

#5

Ah, I think the difference is not in the appreciation of either currency actually, but rather it’s the forward rates that matter. So roll yield implies two contracts (rolling out of one into another). Just reread the question - it just says they sold SEK/EUR futures. Ok. Then, without going into the performance of SPOT rates, it just says that at some later point there is a forward premium on that currency exchange rate. Since the investor is short and will roll into another short position, there will be a positive roll yield due to the forward premium. The question is talking only about FORWARD rates, and not appreciatio/depreciation of SPOT rates. Does this help?

#6

Actually, the question states that the forward points for the SEK/EUR swung to a premium, so I guess it implied that the original curve was downward sloping.

In any case, the forward is sold already, so is the question asking

  1. what will happen to the new forward when the already-sold forward terminated?

Or

  1. what is the outcome of the already-sold forward?

Because if it is 2, at the termination, the already-sold forward will require the person to sell 1 EUR and get 1 SEK, while the market is 2 SEK = 1 EUR. In other words, if this person did not sold the future, the result will be better off. Am I wrong?

If it is 1, then I can understand that since the premium increased, the newly-sold forward will have higher roll yield than the already-sold forward.

Clarification appreciated, thanks.

#7

if you’re long futures and the futures price declines, rolling over your contract at expiration will generate a positive roll yield

if you’re short futures and the futures price appreciates, rolling over your contract at expiration will generate a positive roll yield

in the example it’s cheaper to maintain your short EUR exposure at contract expiration than it was before generating positive rolll yield

#8

I am even more confused…

According to the curriculum, roll yield is defined as the change of futures prices minus the change of spot prices.

Hence, if the change of future prices is negative (future price declines), then the roll yield should be negative (assuming spot price held constant)…

Am I wrong?

#9

If the futures price is below the current spot price then the roll yield will be positive, assuming you are long the futures

#10

That’s right. But two points about it 1 - That negative roll yield is for a long position. If you’re short in that same situation, the roll yield will be positive. 2 - unlikely that the forward price would change and the spot would be unchanged, but for math purposes to illustrate your point - all good. Just cant make the connection in that case to the negative roll yield equaling the forward discount. In the original example you stated, it does not give the change in spot. All we know is that the currency is trading at a forward premium, and the investor is short. That example is really not more complicated than that.

#11

For sdanalyst, yes, that I understand, but the question now is between future prices, not future vs. spot.

For KeepOnTruckin, as you said, if the future prices decline, long position will have negative yield. In the question, the future price increased, and the person is shorting --> isn’t this mean negative yield?

Anyways, back to the original topic, Curriculum Vol. 5, P.292 Q22 the forward is sold already, so is the question asking

  1. what will happen to the new forward when the already-sold forward terminated?

Or

  1. what is the outcome of the already-sold forward?

Because if it is 2, at the termination, the already-sold forward will require the person to sell 1 EUR and get 1 SEK, while the market is 2 SEK = 1 EUR. In other words, if this person did not sold the future, the result will be better off. Am I wrong?

If it is 1, then I can understand that since the premium increased, the newly-sold forward will have higher roll yield than the already-sold forward.

Clarification appreciated, thanks.

#12

Ok - a little confusion here. Your specific example of holding the spot constant, but somehow having a decline in the forward rate…would mathematically equate to a negative roll yield. However, this controlled example cannot be applied to another question, because it’s not an apples-to-apples comp. I’m not too familiar with forex, but from the math I’m thinking this is not a realistic situation (which is why the conclusion cannot be applied elsewhere - negative roll yield for a long positoin when the forward rate is declining).

#13

For KeepOnTruckin, my question is simply that specific question (Q22) in the curriculum.

I think I am clear now, the question is actually asking what the new-hedge will experience, instead of the already-sold hedge.