The question is sourced from IFT mock exam 1 AM - Risk Mgmt.
a chinese cotton producer is selling mainly in europe. cotton price (quoted in eur) is strongly positive related to domestic currency cny. Question is whether the company should hedge mkt risk and/or currency risk.
Solution key says No, should not hedge for either mkt risk or currency risk. The explanation is fairly wordy and long and confusing. So could someone please share his/her idea on this?
It’s natural hedge - the two things offset each other. There is a long example in the CFAI EOCs only with oil but same thing. Commodity exporting country whose domestic ccy value depends on commodity exports.
It’s I think EOC No. 16. in the relevant Reading, the No. of which I don’t know, and honestly I don’t even know what topic is this, but pls check it in the curriculum, you’ll understand it.
THANK YOU !
I thought you hedge the currency if the correlation between asset and currency are high, aka fixed income.
foshizzle, think this way: if correlations are high between the security and the FX, the moment when you should hedge (with the benefit of hindsight here), i.e. the moment when the FX turns south, is the same moment where you have less ‘quantities’ of the security priced in foreign currencies. so, you need to hedge less amounts of the security that is losing value because of FX fluctuactions.
I’m thinking of this another way. True/False?
Cotton is strongly positively correlated with chinese currency (domestic). That implies it is negatively correlated with Euro (foreign).
Because of negative correlations with foreign currency, you should not hedge.