An asset manager says he has perfectly hedged an equity portfolio that is denominated in a foreign currency by only using forward currency contracts. We know then that the:
asset manager is not telling the truth.
Since the asset manager cannot know the future value of the equity position, it is impossible to perfectly hedge the position with only currency contracts.
Question 1: If so, how do we do a perfect hedge on this?
In the Kaplan book, it states "Managers use various strategies for managing the currency risk of a foreign portfolio, including:
a. hedging a minimum future value below which they feel the portfolio will not fall
b. hedging the estimated future value of the portfolio
c. hedging the initial value
None of these strategies can eliminate all the currency risk.
Question 2: if so, does it mean perfect hedging does not even exist?
From the first question’s answer “it is impossible to perfectly hedge the position with only currency contracts.”, sounds like if we use something else, we could do a perfect hedge. Maybe this is just one of those questions…
Technically, perfect hedge does exist, but it is costly (cost-benefit analysis is necessary here) and its characteristics change as the underlying value changes (rebalancing).
Depends on what kind of hedging you’re talking about Gurifissu. The ex-ante beta and duration can change from hedge initiation to hedge lift off. The ex-ante beta and duration are based on historical data or a hedger’s expectations, no one really knows how those will behave/morph overtime, hence the need for constant rebalancing. Furthermore, hedging usually locks in the initial basis which can and does usually change over time.