On the June CMEINDEX futures contract traded at 10345 At this

On the june cmeindex futures contract traded at 10345

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On March 11, 2003, the June CME$INDEX futures contract traded at 103.45. At this price, the notional value of each contract was $103,450. Since the fund manager wanted to hedge half of his currency exposure, he bought 483 dollar index contracts, a number which he derived by dividing $50 million by $103,450. In purchasing CME$INDEX futures contracts, the fund manager took on a position that was long the U.S. dollar and short a basket of seven currencies, thereby hedging his exposure to the underlying currency risk. Scenario A Suppose that during mid-May 2003, the US dollar begins to reverse its course. By early June, the U.S. dollar is up 3.5% on average, and the pension fund has cut back on its exposure to overseas equity markets by 25%. The CME$INDEX June futures contract is now trading at 107.20 and if he so desires, the fund manager can sell 121 contracts at this price, or 25% of his 483 contract holdings, in order to book a gain of $453,750 on his currency hedge. In this instance, the unhedged portion of the portfolio would result in a loss due to the strengthening of the U.S. dollar. The remaining 362 CME$INDEX futures contracts could then be rolled over to the next quarterly contract. Scenario B Referencing Scenario A above, assume that the U.S. dollar instead remains weak and is down by 2% by early June. The fund manager can take physical delivery on 121 contracts, whereby he would receive US dollars and would pay the appropriate amount of each of the seven currencies in the index. (In a simple scenario, he would be using the foreign currency proceeds from the sale of various stocks to make these payments.) This hedge has simply reduced the potential gain from the US dollar weakness. Conclusion During periods of intense market risk, issues related to hedging different risk factors become critical. This paper has focused on currency risks. We started with a complete definition of currency effect on foreign portfolio returns, and argued in favor of protecting against this risk. The main benefit of a full hedge would be in the form of a reduction in portfolio volatility. Fund managers can choose from a range of instruments to hedge their currency risks. The paper argues that exchange-traded futures contracts have certain advantages that
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make them suitable for managing single currency as well as multiple currency exposures, providing examples of hedging U.S. dollars versus Mexican pesos and hedging equity portfolio risk using the new CME$INDEX. 1 See “Currency – A New Look at the Zero Sum Game”, Neil Record, Institute for Fiduciary Education, conference proceedings, July 2000, available at - PDFs/Record700.pdf 2 See “Currency Management: Have the Merits for Hedging Weakened?” Bob Noyen, Institute for Fiduciary Education, conference proceedings, October 1991, available at . 3 See “Holding on to the Currency Bonanza” John R. Taylor, Jr., available at - concepts.com/Papers/bonanza.pdf.
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