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)We can buy a forward contract to hedge the exchange risk associated with british stocks .So if prices of a brtish stock gets appreciated ,then The gain in stock portfolio will be offset byvloss in forward contract.

so overall risk will be minimised.

b)yes,If interest rate parity holds,it will limit the effectiveness of a forward contract,as there will be no arbitrage opportunity.

C)You can buy a call option against your sell postion in british stock .

so If price gets appreciated ,you will exercise the put option otherwise you will not.

D)The company should use a forward contract or option contract as they could gain arbitrage opportunity if interest rate parity theorem not holds a..At the same time they can also hedge there portfolio against possible risk of price falls.

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