Hedging

A dollar-based investor buys a fund holding shares of companies that report results and pay dividends in a foreign currency. Which additional risk has she taken on?

1. A.Prepayment risk, because foreign issuers may repay their obligations earlier than scheduled.Wrong. Prepayment risk belongs to mortgage-backed and similar amortizing debt, not to holdings of equity.
2. B.Currency risk, because the returns must eventually be converted back into dollars.Correct. Even if the shares perform well abroad, an adverse exchange rate move can erase the gain in dollars.
3. C.Reinvestment risk, because foreign dividends arrive on a different payment schedule.Wrong. Reinvestment risk concerns the rate available on cash flows and is not created by a payment calendar.
4. D.Call risk, because foreign shares may be redeemed by their issuers without notice.Wrong. Call features attach to bonds and preferred issues rather than to ordinary common shares.

Why: An investor whose spending is in dollars ultimately measures returns in dollars, so any holding denominated in another currency carries two exposures: how the investment performs and how the currency moves. A foreign portfolio can gain in local terms and still lose in dollars if that currency weakens. The exposure is present no matter how many different foreign companies the fund owns, because it attaches to the currency rather than to any issuer. Hedging the currency, rather than adding more foreign names, is what addresses it.

A bond investor is worried that one of her issuers might default. Which action most directly addresses that particular concern?

1. A.Shortening the average maturity of the bonds held in the portfolio.Wrong. Shorter maturities blunt interest rate risk, and a short bond from a failing issuer still defaults.
2. B.Buying index put options on a broad stock market index.Wrong. A hedge on equity indexes says nothing about whether a particular borrower will pay its debts.
3. C.Moving the portfolio from fixed-rate into floating-rate securities.Wrong. Floating coupons protect against rising rates while leaving the issuer's ability to pay untouched.
4. D.Spreading the portfolio across many unrelated issuers.Correct. Default risk is issuer-specific, which makes it the classic exposure that diversification reduces.

Why: Credit risk attaches to a particular borrower, which places it in the nonsystematic category and makes it shrink as a portfolio holds more unrelated issuers. Each of the other actions addresses a different exposure: maturity governs interest rate sensitivity, floating coupons answer rising rates, and index options hedge broad equity moves. Diversification does not eliminate credit exposure entirely, since a general deterioration in credit conditions widens spreads on nearly everything at once and that portion is systematic. What it does is keep any single failure from being decisive.

An adviser hedges a client holding in a single mid-sized company by selling broad index futures. The principal limitation of this hedge is that

1. A.the holding and the index may not move together, so the hedge can miss entirely.Correct. Company-specific news is exactly the risk an index instrument leaves untouched.
2. B.index futures may not be sold short by anyone who is not an exchange member.Wrong. Either side of a futures contract is open to any customer of a clearing member.
3. C.the hedge removes all risk, which is not permitted in an advisory account.Wrong. No such prohibition exists, and this hedge is far from removing all risk in any event.
4. D.index futures settle physically, so the client would have to deliver shares.Wrong. Broad index futures settle in cash, since delivering an index is not possible.

Why: Hedging one exposure with an instrument on a different underlying leaves basis risk, the risk that the two do not move together. A single company can fall on news specific to itself while the index is flat or rising, in which case the hedge pays nothing and the futures leg may even lose money at the same time as the shares do. The narrower the relationship between the hedged item and the hedging instrument, the larger this residual risk becomes. A hedge using options or futures on the company itself, where they exist, removes the mismatch but is usually more expensive.

A client asks to buy protective puts after a sharp market decline is already under way. Compared with buying the same cover during a calm period, he should expect

1. A.a lower premium, on the basis that the decline has already taken place.Wrong. An option is priced on the moves still to come, not on those already behind it.
2. B.the same premium, since the strike and the expiration date determine the price.Wrong. Those set the terms of the contract, and volatility is what puts a price on them.
3. C.a higher premium, because elevated implied volatility raises option prices.Correct. Protection costs most exactly when the market expects the largest further moves.
4. D.a higher premium for calls only, since puts cheapen in a falling market.Wrong. Put prices rise in a decline, both from the move itself and from the volatility increase.

Why: Option prices rise with implied volatility, which itself rises when markets fall and uncertainty increases, so the cost of protection is highest at precisely the moment clients most want it. The buyer is paying more for the same strike and the same expiration simply because the market now expects larger moves. This is the practical reason a hedging decision belongs in the plan before it is needed rather than in the middle of a decline. Buying the cover in calm conditions costs less, but it also means paying for protection in the many periods when it turns out not to be needed.