Risk Management TT question

CFA Level III Derivatives
#1

Could someone help explain the answers to this question (topic test question):

The committee is concerned that Europe’s sovereign debt crisis may lead to volatility in European stock markets and the euro currency. It considers the hedging strategies outlined in Exhibit 4

EXHIBIT 4

HEDGING STRATEGIES

Strategy** Forwards **Futures 1 Sell euro and buy US dollars Buy US stock market 2 Sell euro and buy US dollars Sell European stock market 3 Buy euro and sell US dollars Sell European stock market

Q. Given the committee’s view about the sovereign debt crisis, which hedging strategy is most likely to result in Packer earning the US risk-free rate of return?

  1. Strategy 3
  2. Strategy 2
  3. Strategy 1

B is correct. Shorting European stock market futures, selling euros, and buying US dollars will result in the Packer endowment fund earning the US risk-free rate.

A is incorrect because buying euros and selling US dollars increases the currency exposure. Shorting euro stock market futures hedges Packer’s euro equity market exposure.

C is incorrect because selling euros hedges Packer’s euro currency exposure. He will now earn the euro equity market return hedged back to the US dollar plus the US equity market return.

could someone explain these answers, and how these scenarios earn the risk-free rate in their respective markets? Thank you!

#2

When you hedge the foreign asset risk, you earn the foreign risk free rate. When you do that and hedge the currency risk, you earn the domestic risk free rate.

The euro stock market was hedged using the futures market, and the currency risk was hedged as well.

The math has to do with the (1+Rfx ) X (1+ Rfc ) formula and the covered interest rate parity: F = S(1 + Intdc)/(1+Intfc)