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CFA Level III Chartered Financial Analyst Questions 166–170 (page: 35)

Albert Wulf, CFA, is a portfolio manager with Upsala Asset Management, a regional financial services firm that handles investments for small businesses in Northern Germany. For the most part, Wulf has been handling locally concentrated investments in European securities. Due to a lack of expertise in currency management he works closely with James Bauer, a foreign exchange expert who manages international exposure in some of Upsala's portfolios. Both individuals are committed to managing portfolio assets within the guidelines of client investment policy statements.
To achieve global diversification, Wulf's portfolio invests in securities from developed nations including the United States, Japan, and Great Britain. Due to recent currency market turmoil, translation risk has become a huge concern for Upsala's managers. The U.S. dollar has recently plummeted relative to the euro, while the Japanese yen and British pound have appreciated slightly relative to the euro. Wulf and Bauer meet to discuss hedging strategies that will hopefully mitigate some of the concerns regarding future currency fluctuations.
Wulf currently has a $1,000,000 investment in a U.S. oil and gas corporation. This position was taken with the expectation that demand for oil in the U.S. would increase sharply over the short-run. Wulf plans to exit this position 125 days from today. In order to hedge the currency exposure to the U.S. dollar, Bauer enters into a 90-day U.S. dollar futures contract, expiring in September. Bauer comments to Wulf that this futures contract guarantees that the portfolio will not take any unjustified risk in the volatile dollar.
Wulf recently started investing in securities from Japan. He has been particularly interested in the growth of technology firms in that country. Wulf decides to make an investment of ¥25,000,000 in a small technology enterprise that is in need of start-up capital. The spot exchange rate for the Japanese yen at the time of the investment is ¥135/€. The expected spot rate in 90 days is ¥132/€. Given the expected appreciation of the yen, Bauer purchases put options that provide insurance against any deprecation of the euro. While delta-hedging this position, Bauer discovers that current at-the-money yen put options sell for €1 with a delta of -0.85. He mentions to Wulf that, in general, put options will provide a cheaper alternative to hedging than with futures since put options are only exercised if the local currency depreciates.
The exposure of Wulf’s portfolio to the British pound results from a 180-day pound-denominated investment of £5,000,000. The spot exchange rate for the British pound is £0.78/€. The value of the investment is expected to increase to £5,100,000 at the end of the 180 day period. Bauer informs Wulf that due to the minimal expected exchange rate movement, it would be in the best interest of their clients, from a cost-benefit standpoint, to hedge only the principal of this investment.

Before entering into currency futures and options contracts, Wulf and Bauer discuss the possibility of also hedging market risk due to changes in the value of the assets. Bauer suggests that in order to hedge against a possible loss in the value of an asset Wulf should short a given foreign market index. Wulf is interested in executing index hedging strategies that are perfectly correlated with foreign investments. Bauer, however, cautions Wulf regarding the increase in trading costs that would result from these additional hedging activities. Regarding the Japanese investment in the technology company, determine the appropriate transaction in put options to adjust the current delta hedge, given that the delta changes to -0.92. Assume that each yen put allows the right to self ¥1,000,000.

Albert Wulf, CFA, is a portfolio manager with Upsala Asset Management, a regional financial services firm that handles investments for small businesses in Northern Germany. For the most part, Wulf has been handling locally concentrated investments in European securities. Due to a lack of expertise in currency management he works closely with James Bauer, a foreign exchange expert who manages international exposure in some of Upsala's portfolios. Both individuals are committed to managing portfolio assets within the guidelines of client investment policy statements.
To achieve global diversification, Wulf's portfolio invests in securities from developed nations including the United States, Japan, and Great Britain. Due to recent currency market turmoil, translation risk has become a huge concern for Upsala's managers. The U.S. dollar has recently plummeted relative to the euro, while the Japanese yen and British pound have appreciated slightly relative to the euro. Wulf and Bauer meet to discuss hedging strategies that will hopefully mitigate some of the concerns regarding future currency fluctuations.
Wulf currently has a $1,000,000 investment in a U.S. oil and gas corporation. This position was taken with the expectation that demand for oil in the U.S. would increase sharply over the short-run. Wulf plans to exit this position 125 days from today. In order to hedge the currency exposure to the U.S. dollar, Bauer enters into a 90-day U.S. dollar futures contract, expiring in September. Bauer comments to Wulf that this futures contract guarantees that the portfolio will not take any unjustified risk in the volatile dollar.
Wulf recently started investing in securities from Japan. He has been particularly interested in the growth of technology firms in that country. Wulf decides to make an investment of ¥25,000,000 in a small technology enterprise that is in need of start-up capital. The spot exchange rate for the Japanese yen at the time of the investment is ¥135/€. The expected spot rate in 90 days is ¥132/€. Given the expected appreciation of the yen, Bauer purchases put options that provide insurance against any deprecation of the euro. While delta-hedging this position, Bauer discovers that current at-the-money yen put options sell for €1 with a delta of -0.85. He mentions to Wulf that, in general, put options will provide a cheaper alternative to hedging than with futures since put options are only exercised if the local currency depreciates.
The exposure of Wulf’s portfolio to the British pound results from a 180-day pound-denominated investment of £5,000,000. The spot exchange rate for the British pound is £0.78/€. The value of the investment is expected to increase to £5,100,000 at the end of the 180 day period. Bauer informs Wulf that due to the minimal expected exchange rate movement, it would be in the best interest of their clients, from a cost-benefit standpoint, to hedge only the principal of this investment.

Before entering into currency futures and options contracts, Wulf and Bauer discuss the possibility of also hedging market risk due to changes in the value of the assets. Bauer suggests that in order to hedge against a possible loss in the value of an asset Wulf should short a given foreign market index. Wulf is interested in executing index hedging strategies that are perfectly correlated with foreign investments. Bauer, however, cautions Wulf regarding the increase in trading costs that would result from these additional hedging activities.

Is Bauer correct in stating to Wulf that put options provide a cheaper means of hedging than futures?

Albert Wulf, CFA, is a portfolio manager with Upsala Asset Management, a regional financial services firm that handles investments for small businesses in Northern Germany. For the most part, Wulf has been handling locally concentrated investments in European securities. Due to a lack of expertise in currency management he works closely with James Bauer, a foreign exchange expert who manages international exposure in some of Upsala's portfolios. Both individuals are committed to managing portfolio assets within the guidelines of client investment policy statements.
To achieve global diversification, Wulf's portfolio invests in securities from developed nations including the United States, Japan, and Great Britain. Due to recent currency market turmoil, translation risk has become a huge concern for Upsala's managers. The U.S. dollar has recently plummeted relative to the euro, while the Japanese yen and British pound have appreciated slightly relative to the euro. Wulf and Bauer meet to discuss hedging strategies that will hopefully mitigate some of the concerns regarding future currency fluctuations.
Wulf currently has a $1,000,000 investment in a U.S. oil and gas corporation. This position was taken with the expectation that demand for oil in the U.S. would increase sharply over the short-run. Wulf plans to exit this position 125 days from today. In order to hedge the currency exposure to the U.S. dollar, Bauer enters into a 90-day U.S. dollar futures contract, expiring in September. Bauer comments to Wulf that this futures contract guarantees that the portfolio will not take any unjustified risk in the volatile dollar.
Wulf recently started investing in securities from Japan. He has been particularly interested in the growth of technology firms in that country. Wulf decides to make an investment of ¥25,000,000 in a small technology enterprise that is in need of start-up capital. The spot exchange rate for the Japanese yen at the time of the investment is ¥135/€. The expected spot rate in 90 days is ¥132/€. Given the expected appreciation of the yen, Bauer purchases put options that provide insurance against any deprecation of the euro. While delta-hedging this position, Bauer discovers that current at-the-money yen put options sell for €1 with a delta of -0.85. He mentions to Wulf that, in general, put options will provide a cheaper alternative to hedging than with futures since put options are only exercised if the local currency depreciates.
The exposure of Wulf’s portfolio to the British pound results from a 180-day pound-denominated investment of £5,000,000. The spot exchange rate for the British pound is £0.78/€. The value of the investment is expected to increase to £5,100,000 at the end of the 180 day period. Bauer informs Wulf that due to the minimal expected exchange rate movement, it would be in the best interest of their clients, from a cost-benefit standpoint, to hedge only the principal of this investment.

Before entering into currency futures and options contracts, Wulf and Bauer discuss the possibility of also hedging market risk due to changes in the value of the assets. Bauer suggests that in order to hedge against a possible loss in the value of an asset Wulf should short a given foreign market index. Wulf is interested in executing index hedging strategies that are perfectly correlated with foreign investments. Bauer, however, cautions Wulf regarding the increase in trading costs that would result from these additional hedging activities.

Calculate the total rate of return that Wulf can expect from hedging the principal amount in the British denominated asset with currency futures. Assume that Bauer hedges the principal by selling £5,000,000 in pound futures at £0.79/€ and the value of the investment is £5,100,000. When this hedge is lifted the futures rate is £0.785/€ and the spot rate is £0.75/€.

Albert Wulf, CFA, is a portfolio manager with Upsala Asset Management, a regional financial services firm that handles investments for small businesses in Northern Germany. For the most part, Wulf has been handling locally concentrated investments in European securities. Due to a lack of expertise in currency management he works closely with James Bauer, a foreign exchange expert who manages international exposure in some of Upsala's portfolios. Both individuals are committed to managing portfolio assets within the guidelines of client investment policy statements.
To achieve global diversification, Wulf's portfolio invests in securities from developed nations including the United States, Japan, and Great Britain. Due to recent currency market turmoil, translation risk has become a huge concern for Upsala's managers. The U.S. dollar has recently plummeted relative to the euro, while the Japanese yen and British pound have appreciated slightly relative to the euro. Wulf and Bauer meet to discuss hedging strategies that will hopefully mitigate some of the concerns regarding future currency fluctuations.
Wulf currently has a $1,000,000 investment in a U.S. oil and gas corporation. This position was taken with the expectation that demand for oil in the U.S. would increase sharply over the short-run. Wulf plans to exit this position 125 days from today. In order to hedge the currency exposure to the U.S. dollar, Bauer enters into a 90-day U.S. dollar futures contract, expiring in September. Bauer comments to Wulf that this futures contract guarantees that the portfolio will not take any unjustified risk in the volatile dollar.
Wulf recently started investing in securities from Japan. He has been particularly interested in the growth of technology firms in that country. Wulf decides to make an investment of ¥25,000,000 in a small technology enterprise that is in need of start-up capital. The spot exchange rate for the Japanese yen at the time of the investment is ¥135/€. The expected spot rate in 90 days is ¥132/€. Given the expected appreciation of the yen, Bauer purchases put options that provide insurance against any deprecation of the euro. While delta-hedging this position, Bauer discovers that current at-the-money yen put options sell for €1 with a delta of -0.85. He mentions to Wulf that, in general, put options will provide a cheaper alternative to hedging than with futures since put options are only exercised if the local currency depreciates.
The exposure of Wulf’s portfolio to the British pound results from a 180-day pound-denominated investment of £5,000,000. The spot exchange rate for the British pound is £0.78/€. The value of the investment is expected to increase to £5,100,000 at the end of the 180 day period. Bauer informs Wulf that due to the minimal expected exchange rate movement, it would be in the best interest of their clients, from a cost-benefit standpoint, to hedge only the principal of this investment.

Before entering into currency futures and options contracts, Wulf and Bauer discuss the possibility of also hedging market risk due to changes in the value of the assets. Bauer suggests that in order to hedge against a possible loss in the value of an asset Wulf should short a given foreign market index. Wulf is interested in executing index hedging strategies that are perfectly correlated with foreign investments. Bauer, however, cautions Wulf regarding the increase in trading costs that would result from these additional hedging activities.

Assuming Wulf and Bauer are successful in hedging both the foreign currency exposure and market risk exposure from the appreciation and depreciation of the asset, the expected return would be closest to:

Arthur Campbell, CFA, is the founder of Campbell Capital Management (CCM), a money management firm focused solely on high net worth individuals. Campbell started CCM two years ago after a 25-year career with a large bank trust department. CCM provides portfolios tailored to match the unique situation of each individual client. All of CCM's clientele have balanced portfolios. CCM does not use derivatives or exotic instruments to manage any of its portfolios. CCM's equity style is defined as growth at a reasonable price (GARP). Most of CCM's portfolios are managed under one of the following three approaches:
• Aggressive (10 accounts): 70% stocks and 30% bonds.
• Moderate (4 accounts): 50% stocks and 50% bonds.
• Conservative (25 accounts): 30% stocks and 70% bonds. CCM has recently added the following two clients:
1. Harold Moss, a long-time acquaintance of Campbell. Campbell and Moss agreed to an investment policy statement in which Moss' portfolio will be managed under CCM's Aggressive approach but will have significantly greater exposure to technology stocks than a typical CCM aggressive portfolio.
2. Richard Bateman is a successful businessman with a $5 million portfolio. Bateman wants his portfolio managed using a conservative approach, and he specifically states that no options or futures are to be used.
A current client, Stan North, has decided to retire. North would like to reduce his risk exposure from aggressive to conservative. CCM moves North's account, including its historical performance, to the conservative composite.
At the end of 2008, CCM reports the moderate portfolio composite performance but does not include the associated number of accounts.
CCM reported the 2008 returns on its conservative composite as shown in Figure 1: Figure 1: CCM Conservative Composite Returns: Year Ending December 31, 2007


The data shown in Figure 2 relates to Moss portfolio transactions from the 2nd quarter of 2008. Figure 2: CCM Equity Returns for the Second Quarter of 2008

Campbell wants CCM's composites to be compliant with the Global Investment Performance Standards (GIPS)
®. Should the Moss and the Bateman accounts be added to CCM's aggressive and conservative composites, respectively, to remain compliant with GIPS?