Can somebody comment on LOS 35.a from Schweser- Explain the use of Foreign exchange futures to hedge currency exposure associated with principal value of investment. Why are we considering the return on Future while calculating the total return on Foreign Investment? Ideally while caculating the total return on hedged foreign investment, we should use two exchange Rates. For Initial investment Spot rate of the day when invesment was done and future rate for initial investment and spot rate of the day when investment is liquidating. Not sure why are we comparing the Future currency rates also?
Investor is worried about foreign currency depreciating , so she is hedging against it by shorting currency futures to the extent of initial asset value ( it is not a minimum variance hedge )
The net portfolio return is the return of the foreign asset in investor’s base currency plus the futures return ( which is in base currency anyway ).
There is a small difference between the foreign asset return in the foreign currency and the total return in the base currency because the hedge is not perfect ( it does not hedge the currency effect of the gains in local currency ) . The next LOS deals with trying to hedge that one
Thanks for responding–
Actually there are two parts to this problems - calculating the gain in domestic currency + gain on the future contracts.
I am confused on the second part (G\L on the calculation of the forward contracts). I am confused with how we can round the short position by goin long in the forward contracts. With stocks it is understood, however with currency futures, the long party would expect a currency delivery, than how can we calculate the gain or loss with the fresh future contract.
It will be great if any insight could be provided on this.
There doesn’t have to be currency delivery when the futures is settled. The only currency used in the futures contract is the investor’s base currency.The gain or loss is calculated at settlement as price change times number of contracts times multiplier ,everything in one currency. Dollars in all Contracts on CME .probably I don’t understand yr question
Future are contracts. This means there is an obligation to deliver (as the investor is short) them at the contract rate. So until they are settled, a mark to market valuation will allow the investor to see how she is doing relative to the obligation.
For example a € investor expecting a million in three months might want to lock future rate at 1€/ rate when the spot is 0.95/. In a month lets say the futures are trading 1.15€/,
A 100% hedged contract, would create a loss of 0.15€/$ when considering the investors position after a month.
1mm \* (1-1.15)€/ = €-150k. So if thevspot did not change, the investor would have forgone a favorable exchange rate of €1.15 and settle for €1.0/$ because of the contract.
I guess if the investor waited and entered into the contaract a month later or even not hv hedged if she forecasts an appreciation of a dollar.
Hth