CFA Level III · Cheat Sheet
| Question | Answer | |
|---|---|---|
| Should FX exposure be hedged? | Depends on investor time horizon, currency views, cost of hedging. Long-term investors: partial hedge (50–100%). Short-term: often higher. | |
| What drives forward rates? | Covered Interest Rate Parity (CIP): F = S × (1 + r_dom) / (1 + r_foreign). Foreign currency at discount if its rates are higher | |
| When does hedging "cost" money? | When foreign interest rates > domestic rates. Selling foreign currency forward locks in a lower rate → forgoes higher carry. | |
| Strategic hedge ratio definition | Fixed % of FX exposure to hedge on an ongoing basis (typically 50–100%). Rebalance and roll forwards periodically. | |
| Dimension | Static (Passive) | Dynamic (Active) |
| Method | Fixed % hedge; roll forwards at maturity | Adjust hedge ratio based on FX views/market conditions |
| Upside Capture | Limited; fully hedged to target ratio | Higher if FX view is correct |
| Downside Risk | Predictable; remains at target ratio | Risk of under-hedging if FX depreciates unexpectedly |
| Value-Add | Removes FX risk; no alpha | Requires accurate FX forecasts to generate alpha |
| Cost | Lower (fewer adjustments) | Higher (more transaction costs, active management) |
| Strategy | How It Works | Risk |
| Carry | Borrow low-rate currency, invest high-rate currency. Earn rate differential. | Adverse FX move offsets carry gain (tail risk in stress) |
| Momentum | Trade in direction of recent currency trends | Reversal risk; trends can break suddenly |
| Value | Buy undervalued currencies (vs. PPP, REER models) | Mean reversion is slow; valuation can persist |
| Instrument | When Used | Key Risk |
| Direct Forward | Liquid, major currency pairs | None (assuming counterparty is sound) |
| Proxy Hedge | Illiquid or restricted currency; correlate 3rd currency | Correlation breakdown in stress → hedge fails when needed most |
| Non-Deliverable Forward (NDF) | Emerging markets w/ capital controls | Counterparty risk + basis risk (onshore ≠ NDF rate) |
| Instrument | Payoff | Use Case |
| Put Option (sell FX) | Floor on FX downside; pay premium | Protect portfolio if FX depreciates |
| Call Option (buy FX) | Cap on FX upside; pay premium | Speculative: bet on FX appreciation |
| Risk Reversal | Buy OTM put + sell OTM call | Collar; potentially zero cost if premiums equal |
| Seagull | Collar + sell deeper OTM put | Lower premium cost but adds downside below strike |
| Trap | Correct Thinking | |
| "Hedging costs nothing because CIP holds" | CIP determines the forward rate. If foreign rates > domestic, hedging costs the rate differential in foregone carry. | |
| "Proxy hedges always work because correlations are stable" | Correlations diverge in stress. Proxy hedge may be useless in the crisis it's meant to address. | |
| "A 100% static hedge is best—eliminates all FX risk" | True, but forgoes all FX upside. Dynamic hedge can capture alpha if FX view is correct. | |
| "NDF is the same as forward" | NDF cash-settled (no physical delivery); used for restricted currencies. Carries basis & counterparty risk. | |
| "Higher foreign interest rates always mean the FX will appreciate" | Higher rates → forward discount (not appreciation). PPP suggests long-term reversion, but short-term unhedged returns are volatile. |
✓ Identify the base currency of the investor (domestic) vs. foreign asset. ✓ CIP direction:
Aligned to the CFA Institute Level III curriculum.
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