CFA CFA Level 3 Currency Risk Management-Arbitrage opportunity ?

Currency Risk Management-Arbitrage opportunity ?

  • This topic has 18 replies, 4 voices, and was last updated Apr-17 by Zee Tan.
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    • lakshya25
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      I get that futures price should converge to the spot price at expiry, but then In the examples in currency risk management chapter (the total return on portfolio calculation,Schweser Book4 Pg#116 ), I see that there is a difference between the futures price and the spot price at the time the investment is liquidated.Isnt there an arbitrage opportunity ?

    • Zee Tan
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      I don’t have the book @lakshya – care to include a pic or write it in here? πŸ™‚

    • lakshya25
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      I am talking about the total return calcuation questions ( hedged ) in which we calculate the translation loss/gain and then the return on futures contract.I am confused because if the spot price and futures price converge, why are they expecting us to find the returns in two parts,shouldnt the Spot price equate future price and we directly compare the futures contract price to the spot price…

    • Sophie Macon
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      Sorry @lakshya25. I’m feeling quite thick today, not sure what the question is in detail. Perhaps you have an example question you want to go through, which you could write (or show a picture) here?

    • lakshya25
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      (Taking Euro =E)
      A person in US invests 1m Euro at Spot rate-$1.2888/E . In 90 days,investment grows to E1050000,spot rate – 1.2760$/E.He decides to hedge 1m E by selling 1m E in futures at 1.2891$/E . At the time investment is liquidated and hedge is lifted.futures exchange rate – 1.2763$/E .The Question requires us to find the total return on hedged position.

      My doubt is – If the futures price and the spot price converge on the maturity date,why is there a difference between the spot rate (1.2760$/E) and futures price (1.2763$/E) on the 90th day?

    • jimmyg
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      @lakshya25, if i read the question correctly, the Euro futures were sold (on day 90) for a future time frame, not with a maturity on day 90 itself (which doesn’t make sense).

      The question says ‘at time the investment is liquidated’ – it’s at a future day beyond day 90, which is irrelevant detail for this question. I hope this makes sense?

    • lakshya25
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      @jimmyg, I think the futures contract matures on day 90 because it’s mentioned that at the time hedge is lifted, the spot rate is 1.2760 which is equal to the spot value on the day the investment was liquidated.i.e. investment liquidation date and the maturity date are the same…Moreover why would he sell the futures contract on day 90 if it is a 90 day investment…he must have sold it on the day he invests & pays for it on day 90…

    • jimmyg
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      That’s odd. I read it that if the investment grows to E1,050,000 on day 90. Then he decides to hedge. It doesn’t make sense to hedge a contract on day 90 and liquidate on day 90?

    • Zee Tan
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      @lakshya25 I gotta agree with @jimmyg.

      Day 0: Investor invests in EUR at spot rate (Spot rate = 1.2888)
      Day 90: Investment grows to EUR 1.05M, investor decides to hedge (Spot rate = 1.2760)
      Unknown amount of time after Day 90: Investor liquidates investment (Spot rate = 1.2763)

    • lakshya25
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      But @Zee , Its clearly written in the book (Pg#116) When the investment is liquidated,spot rate is 1.2760

    • Sophie Macon
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      @lakshya25, do remember that not everyone has the Schweser reference books here. I agree with @zee’s and @jimmyg’s assessment though, based on your original written question.

      It’s best to take an image or replicate the question exactly here for us so that we can help properly. Sometimes rewriting the question as per your own interpretation, some important information may be missed or some misinterpretation may occur. Check out @vincentt’s Level 2 questions for best practices.

    • Sophie Macon
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      @lakshya25, would you mind attaching pictures through http://imgur.com/? I think the previous one doesn’t work.

    • lakshya25
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      I tried attaching the image here but an error occured..

      imgur.com/j8kDIPy

    • Sophie Macon
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      Ok, I will attach it as an image here

    • Zee Tan
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      Thanks for posting the question @layskha25.

      It’s true that prices will converge as the contract approaches expiry, however it’s not necessarily guaranteed to be exact. As you say, there will be quite a few parties at the exact time of expiration trying to make a quick profit from differences to the underlying, as well as a flurry of traders trying to roll over to the next contract, so you’ll see the price of futures fluctuate in a fairly volatile manner (but centred around the spot price).

      For exam purposes I would say that you can safely assume they will converge (i.e. be close together) but I wouldn’t automatically assume they’re exact. Usually the exam question will specify the spot and futures, or state the assumptions you have to make.

      Hope that helps.

    • Sophie Macon
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      As what @zee said. Plus in real life, they usually won’t converge exactly as there’s transaction costs. Hope this helps @Lakshya25. Thanks for putting up the question!

    • lakshya25
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      Yea.Makes sense.Thanks a lot @Zee and @Sophie πŸ™‚

    • Sophie Macon
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      You’re welcome @lakshya25!

    • Zee Tan
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      np @lakshya25 πŸ™‚

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