As a portfolio manager of a US-based financial institution, you are responsible

Question

As a portfolio manager of a US-based financial institution, you are responsible for managing domestic and international investments of your institution. Approximately 25 percent of the stock portfolio you manage is British stocks. Your expectation is that the British stock market will perform well over the next year. Therefore, you plan to sell the stocks one year from now and then convert the British pounds received to dollars at that time. However, you are worried that the British pound may depreciate against the dollar over the next year.

a. Explain how you could use a forward contract to hedge the exchange rate risk associated with your position in British stocks.

b. If interest rate parity holds, does this limit the effectiveness of a forward contract as a hedge?

c. Explain how you could use an options contract to hedge the exchange rate risk associated with your position in stocks.

d. Assume that, although you are worried about the potential decline in the pound’s value, you also believe that the pound could appreciate against the dollar over the next year. You would like to benefit from the potential appreciation but also wish to hedge against the possible depreciation. Should you or should you not use forward contract or options contracts to hedge your position? Explain.

Explanation / Answer

a)A forward contract is a way for a buyer or a seller to lock in a purchasing or selling price fro an asset , with the transaction set to occur in future.so by taking forward cover you will freeze your selling price ,and in future whatever the actual spot price, you will sell it using forward price.

b)Interest rate parity plays a essential role in foreign exchange market, connecting interest rates, spot rates and foreign exchange rate.

It says what should be the forward price if interest rates in two countries differs,However actual forward can be higher or lower than Forward price under Interest rate paritytheorem.

so if interest rate parity holds,It limiys the effectiviness of a forward contract as a hedge.

c)you can buy a Put option (Right to sell) by paying appropriate premium at present and in future .if price goes favorable , you can exercise the option anf if goes unfavorable ,you will not exercise the option.

d)If you are not sure about price movement , you can buy both a "call option (Right to buy )and put option (Right to sell)..In case if price goes unfavorable(depreciate) ,you will get benefit under put option and not to exercise call option..However if price goes Favorable(Appreciate) ,you will get benefit under call option and not to exercise put option.

so whether price goes favorable or unfavorable,you will benefit in either case.

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