2014 Mock version 2 Lehigh case Q5

[rosepetal]

There’s no further explanation in the answer. Can someone explain to me why this strategy (sell euro and buy US dollars, sell European stock market) would earn US risk free rate? Thanks!!
Q5. 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?
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:
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

 

[rosepetal]

Can anyone help out? Thanks!

 

[jsshuai158]

hedge stock going down, short index futures
hedge currency deprieciation, short euro forward.

 

[cgottuso8190]

If I recall correctly, Packer is a US company long European securities (maybe even an equity index?).

• If you sell the Euro, you are now hedged against declines in the Euro, eliminating that currency risk.
• If you sell the Euro stock market, you are now hedged against a decline in your European equity position.
• If you buy the US dollar, because you’re hedged against both depreciation in the Euro and the European equity index, your only exposure is to the USD, which will presumably earn the risk-free rate.

 

[rosepetal]

Thanks!

 

[crosstheevil]

cgottuso8190 wrote:
If I recall correctly, Packer is a US company long European securities (maybe even an equity index?).

• If you sell the Euro, you are now hedged against declines in the Euro, eliminating that currency risk.
• If you sell the Euro stock market, you are now hedged against a decline in your European equity position.
• If you buy the US dollar, because you’re hedged against both depreciation in the Euro and the European equity index, your only exposure is to the USD, which will presumably earn the risk-free rate.

I love this logic but when you buy USD not US government bonds, how can you earn the risk free rate? Is it implied that you put your USD in a bank?

 

[S2000magician]

crosstheevil wrote:

cgottuso8190 wrote:If I recall correctly, Packer is a US company long European securities (maybe even an equity index?).

• If you sell the Euro, you are now hedged against declines in the Euro, eliminating that currency risk.
• If you sell the Euro stock market, you are now hedged against a decline in your European equity position.
• If you buy the US dollar, because you’re hedged against both depreciation in the Euro and the European equity index, your only exposure is to the USD, which will presumably earn the risk-free rate.

I love this logic but when you buy USD not US government bonds, how can you earn the risk free rate? Is it implied that you put your USD in a bank?

Yes.
Put another way: what idiot would leave his cash idle when he could earn the risk-free rate?
Cash is always – always! – assumed to grow at the risk-free rate.

 

[crosstheevil]

S2000magician wrote:

crosstheevil wrote:

cgottuso8190 wrote:If I recall correctly, Packer is a US company long European securities (maybe even an equity index?).

• If you sell the Euro, you are now hedged against declines in the Euro, eliminating that currency risk.
• If you sell the Euro stock market, you are now hedged against a decline in your European equity position.
• If you buy the US dollar, because you’re hedged against both depreciation in the Euro and the European equity index, your only exposure is to the USD, which will presumably earn the risk-free rate.

I love this logic but when you buy USD not US government bonds, how can you earn the risk free rate? Is it implied that you put your USD in a bank?

Yes.
Put another way: what idiot would leave his cash idle when he could earn the risk-free rate?
Cash is always – always! – assumed to grow at the risk-free rate.

Tks magician for confirming this.