Question

Assume you are a junior member of the IPC (Investment Policy Committee) of a money management firm that manages a large pension fund. 10% of the investments, approximately $100,000,000 are invested in companies that are foreign and operate exclusively in the Eurozone (Those countries that operate as members of the European Union and use the euro as the single currency). The IPC is concerned about the recent instability of the euro, and asks you to work up some recommendations on how to hedge that portion of the portfolio that is exposed to currency and interest rate risks, as well as any other risks you may perceive. Write up your specific recommendations, fully explaining why your recommendations would potentially solve the problems.

Answer 1

Ans ) Currency risk and interest risk on the foreign currency exposure can be hedged using the derivative products which tackle different risk like currency and interest rate. We can use interest rate swap , exchange rate forward, options on currency etc., but the best solution to hedge both currency and exchange rate risk is currency swap.

Currency swap is a financial instrument used for hedging both interest rate and foreign exchange risk . In this case the exposure is around $100 Million thus we should enter into the currency swap of $100 Million which will reduce the exposure of the currency and interest rate risk. If there is any loss happened due to the currency rate change or interest rate exposure it can be mitigated by the exposure with the currency swap which will be in profitable position and mitigate the risk of currency change and interest rate change.