2011 Morning Session #8c - Am I going crazy?

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montanidate

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I’m obviously missing something really simple here:
The problem statement says that the “principal value of the portfolio is currency hedged using a three-month forward contract”. So If they sell forward at the rate of .87PLN = 1LHS, why in the answer key do they have them converting back to PLN at the Spot rate of .80? Shouldn’t they get to convert the principal back at .87?
Like I said, I’m obviously missing something really simple here, it’s 10:00PM on Friday night and I’ve been working since 7:30 AM, maybe time to call it a night… . .
If someone can help me out here, I’d be glad to help them on a ridiculous question they have… . (after some rest of course. . )
 
[Bond /Equity] Profit/Loss =Vt*St-V0*S0
[Short Forward] Profit/Loss =Exposure*[F-St]=35000000*[0.87-0.8]=2450000
i suppose the answer given is inaccurate since the value of a forward contract is zero at inception anyways…so when the answer says ‘Initial value of fwd is xxx’ …it is wrong by defintion….i may be wrong here…but it seems a bit sloppy.
oh and fyi …yes you are going crazy…welcome to a place i call home.
 
This seems to be an anamoly.
They have not considered the principal hedging at forward rate. No apparent reason as of now.
 
not sure if I am understanding what is being said.
Portfolio Original Value = 35 Mill LHS = 35 * 0.87 = 30.45 PLN
Final:
Bonds = 25 * 1.1 * 0.80 = 22 Mill PLN
Equities = 10 *.8 * .8 = 6.4 Mill PLN
Forwards = - 35 ( 0.8 - 0.87 ) = +2.45 Mill PLN
End Value Portfolio = 22 + 6.4 + 2.45 = 30.85 Mill PLN
Gain = 0.40 Mill PLN
Seems to be perfectly fine.
Where is the discrepancy, please point it out to me again???
 
cpk, i think you have cleared the doubt. I do not have access to ques right now though. Let me read it again once i can .
I think by separating account (i.e investment in foreign asset & investment in currency futures) you are bang on target.
It reminded SCH words for the exams relating to these type of question: do not try shortcuts. That is calculate the unhedged return (i.e. at spot rate at the time of entering the position & current spot rate) & calculate the return on futures contract to arrive at the total return.
 
I used the “Stalla” method and came up with gain of $460K, not sure if they gave me full credit or not….
Stalla way:
unhedged = (1+LCR)(1+LMR) -1 = -6.73%
hedged = unhedged from above - (F1 - F0 / S0) = -6.73% - (-8.055) = +1.32%
1.32% * 35M = gain of 460K
anyone else do it this way?
 
How did you arrive at those numbers?
What did you consider the market? ( because Bonds and Stocks movements are different )
 
market return:
bonds beg value = 25, end value = 25(1.10) = 27.5
equity beg value = 10, end value = 10(.80) = 8
end total value = 35.5
beg total value = 35
gain = 35.5 / 35 -1 = 1.43% for local market return
local currency return = s1 / s0 -1 = .80 / .87 - 1 = -8.05%
so, unhedged return = (1+LCR)(1+LCM) - 1 = (-.9195)(1.0143)-1 = -6.73%

thus, hedged return = -6.73 - (f1 - f0 / s0) = -6.73 - ( -.0805) = gain of +1.32%
 
This might work for an entire portfolio that moves in a parallel manner.
for the individual components - bonds and stocks that move differently… it is not entirely evident from the text whether this method is applicable. That is all I can think of.
and I am also not sure if they will give credit for this approach. They might give partial credit, but not sure at all.
 
cpk you know everything!…..how does the partial credit grading system work?
 
  • For an question like this, studying Notes/Books has little help.
  • Quickly creating a Table and filling it with a calculated data is the key.
  • Bullet, Equation and Table are three popuar structures in standard answers.
 
i dont think you’d get more than 2 points (out of 5) for the second post - you didnt calcualte the final gain/loss for the portfolio, only the forward
 
CPK,
Thank you! This is going to sound ridiculous, but after glancing at your answer, I realized my problem was “not reading the question statement.” I glazed over the table with the securities and the market value assuming the final row was simply a portfolio total without reading its description “Notional value… ” . I’m actually glad this came up though, especially as I work through CFAI’s solutions to these past morning sessions because it is a great example of the difference between how Schweser and CFAI present solutions and problem solving methods. The method you demonstrated is exactly how Schweser works through these hedging problems; treat the underlying positions separate from the hedge. This is how i prefer to logicly solve the problem as well. CFAI’s solution gets you the same answer, but in a very unintuitive way.
I owe you one. Got any ridiculous questions I can dive into?
 
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