CFAI R27: Risk Management EOC Q16 (Natural Hedge)

Question

Guys, I am only half getting this. Could you please explain to help me bed down the concept. I find the CFAI answers rather confusing. Thanks!!!

Question:
Ricardo Colón, an analyst in the investment management division of a financial services firm, is developing an earnings forecast for a local oil services com- pany. The company’s income is closely linked to the price of oil. Furthermore, the company derives the majority of its income from sales to the United States. The economy of the company’s home country depends significantly on export oil sales to the United States. As a result, movements in world oil prices in U.S. dollar terms and the U.S. dollar value of the home country’s currency are strongly positively correlated. A decline in oil prices would reduce the com- pany’s sales in U.S. dollar terms, all else being equal. On the other hand, the appreciation of the home country’s currency relative to the U.S. dollar would reduce the company’s sales in terms of the home currency.

According to Colón’s research, Raúl Rodriguez, the company’s chief risk officer, has made the following statement:
“The company has rejected hedging the market risk of a decline in oil prices by selling oil futures and hedging the currency risk of a depreciation of the U.S. dollar relative to our home currency by buying home currency futures in U.S. markets. We have decided that a more effective risk management strategy for our company is to not hedge either market risk or currency risk.”
A)	State whether the company’s decision to not hedge market risk was correct. Justify your answer with one reason.
B)	State whether the company’s decision to not hedge currency risk was correct. Justify your answer with one reason.

Answer:
A)	The decision not to hedge this risk was correct. Suppose the company had hedged this risk. If the price of oil were to increase, the favorable effect of the increase on income would be offset by the loss on the oil futures, but the home currency should appreciate against the U.S. dollar, leaving the company worse off. If the price of oil were to decrease, the unfavorable effect on income would be offset by the futures position and the home currency should depreciate, leaving the company better off. In short, the company would remain exposed to exchange rate risk associated with oil price movements.

B) 	The decision not to hedge this risk was correct. The company should remain exposed to market risk associated with exchange rate movements (i.e., currency risk). Hedging would remove currency risk but leave the company with market risk associated with oil price movements. If the home currency declined, the price of oil would likely decline because it is positively correlated with the U.S. dollar value of the home currency. That would be a negative for income. On the other hand, appreciation of the home currency is likely to be accompanied by an oil price increase, which would be positive for income.

vincentt · Answer

I might not get this right but this is my understanding:

Statement 1
"As a result, movements in world oil prices in U.S. dollar terms and the U.S. dollar value of the home country’s currency are strongly positively correlated."
Would mean:
oil price up (down)  domestic currency against USD up (down)

Statement 2
"A decline in oil prices would reduce the com- pany’s sales in U.S. dollar terms, all else being equal"
Would mean:
oil prices up (down)  company's sales in USD up (down)

Statement 3
"On the other hand, the appreciation of the home country’s currency relative to the U.S. dollar would reduce the company’s sales in terms of the home currency."
Would mean:
domestic currency against USD up (down)  company's sales in domestic currency down (up)

Hence:
domestic currency against USD down -> oil price down -> company's sales in USD down

Hedge Market Risk:
domestic currency against USD down -> oil price down (hedged) -> company's sales in USD down

Even if you hedged the oil price, the company's sale in USD will still go down as mentioned in Statement 2 (oil prices is positively correlated with company's sales in USD)

Hedge Currency Risk:
domestic currency against USD down (hedged) -> oil price down -> company's sales in USD down

The company may hedged the domestic currency against USD for the amount of sale, however though the amount is hedged when domestic currency depreciates oil prices will go down which will affect the company's sales in USD. Though you may argue that the depreciated domestic currency (stronger USD will result in higher domestic currency amount after conversion) might offset the reduce company's sales in USD.

Hope that helps.