liquidity needs and currency hedge

[jsshuai158]

2014 cfa text vol 5, page 276. q1.
an example from the cfa text is confusing me. hope someone could clarify for me.
if a client requests withdrawal from a fund, and the fund is just rebalanced for currency hedge. what should happen to the currency hedge after the withdraw?
a. do nothing
b. reduce the hedge ratio
c. over-hedge by using currency options.
thanks in advance

 

[cpk123]

I think - hedge ratio should be reduced.
Why I think so? Portfolio was just balanced for the hedge. So it is now balanced (after the rebalance). You are reducing the amount of the portfolio - due to the withdrawal. So you need less hedging at this point in time - after funds have been withdrawn.
Do nothing - not an appropriate option - portfolio is now smaller. keeping the hedge the same will cause negative performance impact.
over hedge with currency options - option would not be exercised in case the currency moved in the other direction - but you lose the premium paid - to go long the option - so negative impact on the portfolio.

 

[jsshuai158]

cpk123, i chose b as well. it’s intuitive to reduce the hedge when the underlying exposure is reduced by the withdrawal.
the answer is however a. the explanation given was that when the the hedge was just rebalanced, the currency risk is at its minimum, and it’s desirable when high liquidity needs arises. this does not make a lot of sense to me.