Currency Investment Management Flashcards

Question 1

What is currency risk in an investment portfolio?

Accepted Answer

Currency risk is the chance that exchange rate changes will alter an investment's value when measured in the investor's base currency. A foreign asset can gain in its local currency yet lose value for a home investor if that currency weakens. This risk is separate from the asset's own return.

Question 2

What is a base currency and why does it matter?

Accepted Answer

The base currency is the currency in which an investor measures performance, reports results, and pays liabilities. It matters because the same foreign holding produces different returns depending on the base currency chosen. Changing it can alter the apparent risk and return of every position in a portfolio.

Question 3

What is transaction exposure and how does it arise?

Accepted Answer

Transaction exposure is the risk that a known future cash flow in a foreign currency will change in base currency value before it is settled. It arises from contracted items such as receivables, payables, dividends, or purchase commitments priced in another currency. Its amount and timing are often known, which eases hedging.

Question 4

How does translation exposure differ from transaction exposure?

Accepted Answer

Translation exposure is the accounting effect of converting foreign subsidiary financial statements into the parent's reporting currency. It changes reported equity and earnings without any cash changing hands. Transaction exposure involves real future cash flows that will be settled, while translation exposure concerns the book value of foreign assets and liabilities at reporting dates.

Question 5

What is economic exposure, sometimes called operating exposure?

Accepted Answer

Economic exposure is the long-term risk that exchange rate movements will change a company's future cash flows, competitiveness, and market value. It affects firms that sell or source across borders even if they hold no foreign-currency contracts today. A stronger home currency can make exported goods more expensive abroad and reduce future sales volume.

Question 6

What do direct and indirect exchange rate quotes mean?

Accepted Answer

A direct quote states the price of one unit of foreign currency, such as dollars per euro. An indirect quote states the amount of foreign currency needed to buy one unit of domestic currency, such as euros per dollar. They are reciprocals, so either converts to the other by taking its inverse.

Question 7

What does a hedge ratio measure in currency risk management?

Accepted Answer

A hedge ratio is the proportion of a foreign currency exposure that is offset with a hedging instrument. A fully hedged position uses a ratio of one hundred percent, while a partial hedge covers only part of the exposure. Choosing it balances protection against cost and missed gains.

Question 8

What is a natural hedge in currency management?

Accepted Answer

A natural hedge reduces currency exposure by matching foreign currency revenues with foreign currency costs, rather than using financial contracts. A company that earns euros and also pays its European suppliers in euros needs less protection against euro movements. Natural hedges can be cheaper than derivatives, but they are often incomplete.

Question 9

What does purchasing power parity suggest about exchange rates?

Accepted Answer

Purchasing power parity suggests that exchange rates adjust over time so that identical goods cost about the same in different countries when priced in a common currency. Relative PPP focuses on changes, predicting that a currency with higher inflation tends to depreciate by roughly the inflation gap. Real-world deviations are common.

Question 10

What does covered interest rate parity state about forward exchange rates?

Accepted Answer

Covered interest rate parity states that the forward exchange rate adjusts so that a hedged foreign investment matches the domestic return. If the foreign interest rate is higher, the foreign currency trades at a forward discount that offsets the yield advantage. Any gap would create riskless arbitrage, which keeps deviations small in liquid markets.

Question 11

How does uncovered interest rate parity differ from the covered version?

Accepted Answer

Uncovered interest rate parity says the expected change in the exchange rate offsets the interest rate difference between two currencies, without using a forward contract. It rests on expectations rather than arbitrage, so it can fail in practice. Often, high-yield currencies do not depreciate as much as the gap implies, which underpins carry trading.

Question 12

How does the international Fisher effect link interest rates and expected currency changes?

Accepted Answer

The international Fisher effect proposes that a currency with a higher nominal interest rate is expected to depreciate by about the rate difference. It builds on the Fisher relation between nominal rates, real rates, and expected inflation. The theory assumes real interest rates are similar, so differences in nominal rates mainly reflect expected inflation.

Question 13

What does the Balassa-Samuelson effect explain about price levels across countries?

Accepted Answer

The Balassa-Samuelson effect explains why price levels tend to be higher in countries with higher productivity in traded goods. Fast productivity gains in export industries raise wages, and those wages spread to the non-traded service sector, pushing up local prices. This means real exchange rates can appreciate as an economy develops.

Question 14

What is exchange rate overshooting, and why does it occur?

Accepted Answer

Exchange rate overshooting describes a currency that moves beyond its long-run equilibrium level before gradually returning. It occurs because prices of goods adjust slowly while financial asset prices, including exchange rates, adjust quickly to news such as a change in monetary policy. The currency later partly reverses as goods prices catch up.

Question 15

What is the difference between nominal and real exchange rates?

Accepted Answer

A nominal exchange rate is the price of one currency in terms of another. A real exchange rate adjusts that nominal rate for differences in price levels between the two countries, showing how much a basket of goods in one country costs relative to another. A rising real rate signals less competitiveness abroad.

Question 16

What is the monetary approach to exchange rate determination?

Accepted Answer

The monetary approach links exchange rates to relative money supplies, income levels, and interest rates across countries. It treats the exchange rate as the relative price of two monies, so an increase in one country's money supply tends to weaken its currency. Prices are assumed to adjust, making this a long-run view.

Question 17

What is a currency forward contract and how is it used?

Accepted Answer

A currency forward contract is an agreement to exchange a set amount of two currencies at a fixed rate on a future date. Investors use it to lock in the base-currency value of a known foreign cash flow. The forward rate reflects the spot rate adjusted for interest rate differences.

Question 18

How does a currency futures contract differ from a forward contract?

Accepted Answer

A currency futures contract is standardized in size and expiry and trades on an exchange with daily margin settlement. A forward is customized between two parties and typically settles only at maturity. Futures therefore reduce counterparty risk through the clearinghouse, but they offer less flexibility in amount and timing.

Question 19

What is a currency option and how does it differ from a forward?

Accepted Answer

A currency option gives the buyer the right, but not the obligation, to exchange currencies at a set strike rate by expiry. The buyer pays a premium for this flexibility. Unlike a forward, which locks in a rate, an option keeps upside if the currency moves favorably while limiting the downside to the premium.

Question 20

How do currency swaps help manage foreign currency debt?

Accepted Answer

A currency swap exchanges interest and principal payments on debt denominated in two currencies over an agreed term. An investor or issuer can use it to convert a liability into another currency without refinancing. Swaps are often used for long-dated protection beyond typical forward maturities.

Question 21

What is a cross-hedge and when is it used?

Accepted Answer

A cross-hedge uses a derivative on a related currency when no direct contract exists for the exposure currency or it is too costly or illiquid. A more liquid currency that moves similarly can serve as the hedge. The hedge works only as well as the historical correlation holds, so basis risk remains.

Question 22

How do rolling hedges work, and what cost do they introduce?

Accepted Answer

A rolling hedge repeatedly replaces a short-dated forward or futures contract with a new one as each expires, extending protection over a longer horizon. Its cost depends on the forward points, which reflect the interest rate differential, so a rolling hedge can carry a persistent cost or gain.

Question 23

What is a money market hedge and how is it constructed?

Accepted Answer

A money market hedge creates a synthetic forward position by borrowing and lending in the two currencies. For a future foreign receivable, the investor borrows the foreign currency today, converts it at the spot rate, and invests the proceeds domestically. The loan is repaid with the receivable, locking in a known base-currency value.

Question 24

Why do hedging costs matter when comparing currency protection strategies?

Accepted Answer

Hedging costs include bid-ask spreads, option premiums, and the forward points or interest carry embedded in a rate. These costs reduce the net return of an investment, so a hedge must offer protection worth its expense. Comparing strategies requires looking at expected cost, not only the protection provided.

Question 25

What is currency overlay management and who typically uses it?

Accepted Answer

Currency overlay management separates currency decisions from the underlying asset portfolio by assigning a specialist manager to hedge or actively trade the currency exposure. Large institutional investors such as pension funds often use it to control hedge ratios centrally. The overlay manager trades derivatives on top of the existing holdings.

Question 26

What is a currency carry trade and why do investors use it?

Accepted Answer

A currency carry trade borrows in a low-interest currency and invests in a high-interest currency, earning the rate difference if exchange rates stay stable. The strategy often profits over long periods, but it carries crash risk. When investors unwind positions quickly, the high-yield currency can fall sharply, wiping out accumulated carry.

Question 27

How does a tactical currency view differ from a strategic currency decision?

Accepted Answer

A strategic currency decision sets a long-term policy hedge ratio or currency allocation based on the investor's risk tolerance and liabilities. A tactical view is a shorter-horizon bet that a currency will move, adjusting exposure around the strategic target. Tactical positions are typically smaller and reviewed more often.

Question 28

What is a currency momentum strategy in currency investing?

Accepted Answer

A currency momentum strategy buys currencies that have recently appreciated and sells those that have recently weakened, expecting trends to persist over medium horizons. The signal is usually based on past returns over several months. Momentum can produce gains during sustained trends but tends to lose money when they reverse sharply.

Question 29

What is a value approach to currency investing?

Accepted Answer

A currency value approach compares a currency's current level with a measure of fair value, such as purchasing power parity or real effective exchange rates. Undervalued currencies are bought and overvalued ones are sold, expecting prices to revert over time. Value signals can be slow, however, since misvaluations may persist for long periods.

Question 30

What is a currency volatility strategy and how might it be used?

Accepted Answer

A currency volatility strategy trades the expected size of exchange rate moves, often through options, rather than their direction. An investor who expects calm markets might sell options to collect premium, while one expecting turbulence might buy them. Selling options can produce large losses during a sudden shock.

Question 31

How do currency-hedged and unhedged funds differ for an investor?

Accepted Answer

A currency-hedged fund offsets most exchange rate exposure with forwards, so returns track local asset performance more closely. An unhedged fund leaves the currency exposure in place, so its results combine asset returns with currency gains or losses. Neither is inherently better, since the choice depends on currency views and hedging costs.

Question 32

What is currency beta and how is it estimated?

Accepted Answer

Currency beta measures how sensitively an asset's base-currency return responds to a currency's moves, often estimated by regressing returns on currency changes. A beta near one implies the asset moves almost one for one with the currency. Estimates vary with the sample period and frequency, so treat them as approximate.

Question 33

How can currency exposure affect diversification in a global portfolio?

Accepted Answer

Currency movements often have low correlation with stock and bond returns, so foreign assets can add diversification even if their local returns are similar. However, currency exposure can also raise total volatility, and correlations can shift. Diversification benefit should therefore be measured with the currency effect included, not assumed.

Question 34

How does currency risk budgeting limit exposure across a portfolio?

Accepted Answer

Currency risk budgeting assigns a maximum amount of currency risk, often measured as value at risk or tracking error, to each manager, region, or strategy. Limits are monitored against that budget so that no single currency bet dominates total portfolio risk. Budgets are reviewed periodically, and breaches trigger hedging or position reductions.

Question 35

What is the difference between hedging and speculating with currency positions?

Accepted Answer

Hedging aims to reduce an existing exposure, so the position offsets a risk that arises from another holding or liability. Speculation takes a currency position without an underlying exposure, seeking profit from expected movement. The same instrument can serve either purpose, so documentation and intent matter, particularly for reporting and governance.

Question 36

How is currency risk measured in a portfolio?

Accepted Answer

Currency risk is measured by estimating the volatility of the currency component of returns, such as with standard deviation or value at risk. Analysts isolate it by comparing returns in base currency with returns in local currency, or by using factor models. Results depend on the model and data window, so stress tests help.

Question 37

What is the role of correlation between currencies in portfolio risk?

Accepted Answer

Correlations between currency pairs determine how much risk is reduced or amplified when several currency exposures are combined. Two positions that move together, such as long positions in closely linked currencies, add risk, while offsetting positions can partly cancel. Correlations change over time, so models using old estimates may understate concentration.

Question 38

Why do investors consider currency hedging policies for bonds differently from equities?

Accepted Answer

Bonds typically have lower volatility than equities, so currency moves can represent a large share of their total risk, making hedging a common priority. Equity investors often accept more currency exposure because it can add diversification. The cost of a bond hedge also depends on the interest rate gap between the two currencies.

Question 39

What does a currency mandate typically specify for an asset manager?

Accepted Answer

A currency mandate sets the rules under which a manager may manage exchange rate exposure, including the permitted hedge ratio range, allowed instruments, and limits on active currency bets. It also defines the benchmark and how performance will be measured, often against a hedged or unhedged reference.

Question 40

Why is liquidity important when choosing currency instruments?

Accepted Answer

Liquidity sets how quickly a position can be entered or exited without moving prices. Major currency pairs usually trade with tight spreads, while exotic or emerging market currencies may be costly or hard to unwind during stress. Poor liquidity can make a planned hedge expensive in volatile markets.

Currency Investment Management Flashcards

1Currency Exposure Fundamentals

2Exchange Rate Theories and Parity

3Hedging Instruments and Strategies

4Active Currency Strategies

5Portfolio Construction and Risk Control

Learning Resources