Part A: Peter Smiths is a portfolio manager of Silver global technology fund in Sydney. He is concerned about currency fluctuations related to the equity portfolio. The portfolio is valued in AUD, but has foreign currency exposure, primarily the USD.
Based on his analysis, Peter generates the following forecast:
- Expected return (in USD) of the Portfolio 12.4%
- Standard deviation (in USD) of the portfolio 18%
- Expected FX spot rate in one year 1USD = 1.2047AUD
- Standard deviation of the FX 5%
- Correlation between FX and the portfolio (in USD) – 0.06
AFX dealer provides the following market quote
- USD / AUD spot rate 1.1870
- 1 year USD / AUD forward rate 1.2058 – 1.2079
Peter considers to sell USD and buy AUD using a one-year forward contract to fully hedge USD currency risk. He would like to execute the trade only if he can increase the portfolio return by at least 30 basis points.
Based on Peter’s forecast, should he execute the forward contract? Please justify your responses with calculations.
Part B One of the non-USD FX exposures in Peter’s portfolio is JPY. Peter regularly adjusts his portfolio’s JPY position based on his short-term forecast. Peter predicts JPY will appreciates by 4% against AUD over the next 90 days. The FX spot rate is 84.03 (1 AUD = 84.03 JPY). Peter is considering the following 90-day European options to increase JPY exposure in the following 90 days and simultaneously minimize his cash flow to create option portfolio
- Choice 1: Buy call option on JPY with 87.72 strike price and Sell call with 89.84 strike price
- Choice 2: Buy call option on JPY with 84.03 strike price and Sell call with 87.72 strike price
- Choice 3: Buy call option on JPY with 84.03 strike price and Sell call with 89.84 strike price
Determine which Choice most likely satisfy Peter’s objective at expiration and justify why the OTHER TWO CHOICES are NOT suitable (No more than 50 words).
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