CFA Level 3 - Derivatives Session 14 - Reading 35

CFA Level 3 - Derivatives Session 14 - Reading 35 (Notes, Practice Questions, Sample Questions) 1.1 Jack Tarkenton and Gene Bowman are analysts for the rm Salisbury Consultants. Salisbury provides investment and risk management advice to portfolio managers.One of Salisbury’s largest U.S. clients has taken a position in a German stock portfolio.The value of the position is currently EUR400,000. The client has a one month timehorizon and will hedge translation currency risk with a futures contract that has amaturity of three months. The current and projected portfolio values, spot exchangerates, and futures prices are shown in the table below. To illustrate the e ect ofcurrency risk on foreign portfolio values, Tarkenton will calculate the hedged andunhedged return in dollars and Euros.Original portfolio value in EUR 400,000Original spot exchange rate $1.02Original futures price $0.98Portfolio value in 1 month in EUR 420,000Spot exchange rate in 1 month $1.07Futures price in 1 month $1.03In his presentation to the client, Tarkenton discusses in more detail the hedging ofcurrency risk for foreign investments using foreign currency futures contracts.Describing the basis for foreign currency futures contracts, he states that it isdependent on the covered interest rate parity relationship. Furthermore, Tarkentonstates that basis risk is negligible because, unlike commodities such as corn andsilver, foreign currency has no storage costs.Bowman adds that according to his study of equity and currency markets, hedgingforeign equity risk is not a simple task because there is a relationship betweenforeign stock returns and the changes in foreign currencies. For example, Bowman

states that if the Swiss franc declines by 10%, then on average Swiss stocks increaseby 4%. Bowman states that this relationship is due to the fact that a weaker Swissfranc makes Swiss exports more competitive in world markets.Tarkenton states that if an investor had a portfolio of equities from several countries,he or she would run the regression below to hedge currency risk. As a result, the hterms in the regression would provide the optimal hedge ratios for hedging currencyrisk.R = α + h1F1 + h2F2 + h3F3 + e.Turning their attention to lesser developed countries, Bowman states that investors should pay particular attention to countries with newlyliberalized nancial markets because there are signi cant nancial changes postliberalization as re ected in the country’s stock market performance anddiversi cation bene ts. In particular, he makes the following comments: Statement #1: After a country is liberalized, stock returns in the country decrease,perhaps due to the previously high returns associated with the announcement of theliberalization.Statement #2: From a diversi cation standpoint, the research shows that stock returnvolatility declines post liberalization in the short run. Unfortunately though,liberalization leads to higher correlations and betas between the liberalized countryand world markets.In Tarkenton’s German stock portfolio example, what is the unhedged return in dollarterms? A)5.00%.B)5.25%. C)10.15%. Explanation: C) The return on the unhedged portfolio in dollars factors in the beginning and ending spot rates:The portfolio return in dollars = (€420,000 × $1.07/€) – (€400,000 × $1.02/€) / (€400,000 ×$1.02/€) = ($449,400 − $408,000) / $408,000 = 10.15%.Both the investment in Euro terms and the Euro itself increased in value. The investorbene ted from both

1.2 In Tarkenton’s German stock portfolio example, what is the hedged return in dollar terms? A)15.05%. B)5.25%. C)5.00%. Explanation: B) In a hedge of translation currency risk (i.e. a simple hedge of the principal), the manager would hedge the €400,000 principal. The manager shorts theEuro to hedge their long Euro position in the European stock. The loss on the futurescontracts in dollars = €400,000 × ($0.98/€ –$1.03/€) = −$20,000.The pro t on the unhedged portfolio in dollars = (€420,000 × $1.07/€) – (€400,000 ×$1.02/€) = $449,400-$408,000 = $41,400.In net, the investor has made a dollar return of (−$20,000 + $41,400) / $408,000 = 5.25% 1.3 Regarding Tarkenton’s statement concerning basis risk, Tarkenton is: A)incorrect because basis is dependent on the purchasing parity relationship.B)incorrect because basis is dependent on the purchasing parity relationship andbecause basis risk is not negligible for foreign currency futures contracts. C)incorrect because basis risk is not negligible for foreign currency futurescontracts Explanation: C) Tarkenton is incorrect because basis risk is not negligible for foreign currency futures contracts. If interest rate di erentials in the home and foreigncountry change, the di erence between the spot rate and futures rate (i.e. the basis)will change. The only way for basis risk to be eliminated is if the interest ratedi erential is constant or if the investor matches the maturity of the investmenthorizon with the maturity of the futures contract. In the latter case, the futures pricewill converge to the spot price at maturity.

Covered interest rate parity states that the di erence between the spot rate and theforward or futures price is due to the interest rate di erential between the twocountries 1.4 Given Bowman’s study of the relationship between Swiss stock returns and changes in the Swiss franc, what would be the optimal amount of SF to hedge for anequity portfolio worth SF 500,000 if the investor wished to hedge both translation andeconomic risk? A)SF 125,000.B)SF 500,000. C)SF 300,000. Explanation: C) If the investor was only hedging translation risk, the hedged amount would simply be the principal of SF 500,000 (i.e. a hedge ratio of 1.0). However, inBowman’s calculation, the relationship between Swiss stock returns and the changesin the Swiss franc is -0.40 (4% / −10%). This ratio would hedge economic risk. Tohedge both translation risk and economic risk, the hedge ratio is 0.60 (1 − 0.40). Thus60% of the principal would be hedged, i.e. SF 300,000. 1.5 Regarding Tarkenton’s regression to provide the optimal hedge ratios, what do the R and F terms represent? R term F terms A)Foreign asset return in local currency terms Changes in foreign currenciesB)Foreign asset return in domestic currency terms Changes in foreign asset factors C)Foreign asset return in domestic currency terms Changes in foreign currencies Explanation: C) The R term represents the return on the foreign asset in domestic currency terms (e.g. dollar terms for a U.S. investor) while the F terms representchanges in foreign currency values. The F terms may be the change in foreigncurrency futures prices or the change in foreign currency spot prices. The h terms in

the regression will provide the optimal hedge ratios for determining the amount ofcurrency exposure to hedge. 1.6 Regarding Bowman’s comments on the nancial changes post liberalization, are the comments correct? Statement 1 Statement 2 A)Yes No B)No NoC)No Yes Explanation: A) Statement #1 is correct. When a country’s nancial markets are liberalized, stock returns generally increase as investors bid up the prices of equitiespreviously unavailable to them. After liberalization, stock returns subsequentlydecline, perhaps due to the previously high liberalization returns.Statement #2 is incorrect. It is true that liberalization leads to higher correlations andbetas with world markets. However, the empirical evidence demonstrates thatliberalization does not a ect the volatility of returns in the short run. 2. The manager of a large, multi-currency portfolio is investigating methods to hedge the portfolio. If she regresses the return of the portfolio on several major currencies,she is most likely trying to solve the problem of: A)illiquid forward and futures markets for some currencies. B)the symmetry of the payo of forward and futures contracts.C)the asymmetry of the payo of forward and futures contracts. Explanation: A) The manager’s regression would most likely be part of setting up a cross-hedge, which is to remedy the problem that some of the currencies representedin the portfolio will probably have illiquid forward and futures markets

3. Which of the following equations represents the net pro t/loss on a hedged position, in domestic currency terms? A)V0 (-Ft + F0).B)(Vt* - V0*) / V0*. C)( Vt St - V0 S0) – V0 (Ft - F0) Explanation: C) Recall the following variables used in hedge analysis: V0 – The value of the portfolio of foreign assets at time 0, stated in the foreigncurrency.Vt – The value of the portfolio of foreign assets at time t, stated in the foreigncurrency.Vt* - The value of the portfolio of foreign assets at time t, stated in the domesticcurrency.St – The spot rate, quoted at time t.Ft – The futures exchange rate, quoted at time t.(Vt* - V0*) / V0* is the portfolio rate of return, stated in domestic currency terms. VtSt - V0 S0 is the gain or loss on a portfolio, stated in domestic currency terms. V0 (-Ft +F0) is the gain or loss on a futures position, stated in domestic currency terms.Therefore, the net pro t/loss, in domestic currency, is equal to (Vt St - V0 S0) – V0 (Ft -F0) 4. A U.S.-based investor has purchased a 15,000,000 peso o ce building in Mexico. He has hedged his investment by selling forward futures at $0.1098/peso. Two monthslater, the futures exchange rate has fallen to $0.0921/peso. The investor’s net changein the futures position is: A)$1,647,000. B)-$265,500.C)$265,500

Explanation: A) The realized gain on the futures position is: V0 (-Ft + F0) = 15,000,000 pesos × (-$0.0921/peso + $0.1098/peso) = $265,500 5. A U.S. investor who holds a £2,000,000 investment wishes to hedge the portfolio against currency risk. The investor should: A)sell £2,000,000 worth of futures for U.S. dollars. B)buy £2,000,000 worth of futures for U.S. dollars.C)sell $2,000,000 worth of futures for British pounds Explanation: A) The investor should sell £2,000,000 worth of futures contracts for U.S. dollars. This will o set the existing long position in pound-denominated assets. In sodoing, the investor has e ectively xed the exchange rate for pounds into dollars forthe duration of the futures contract 6. A basic strategy for hedging a portfolio against currency risk, where the investor hedges the foreign currency value of the foreign asset, is called: A)cross-hedging.B)hedging the basis. C)hedging the principal. Explanation: C) Cross-hedging is a strategy whereby a third currency is used to hedge a foreign currency exposure in a currency for which standard hedging vehicles areunavailable. Basis risk is the exposure to changes in the relationship between theforward price of an asset and its spot price. Hedging the principal is the basicstrategy used by managers of foreign portfolios to minimize exposure to currency risk

7. Jill Pope, CFA, is a portfolio manager in the United States that will begin managing a portfolio denominated only in Euros. Her supervisor asks her to hedge the portfolioagainst currency uctuations using an instrument that will e ectively be aninsurance policy against downside risk while o ering upside potential. To do this,Pope: A)should take a long position in $/€ forward contracts. B)should buy put options on the $/€ exchange rate. C)should sell put options on the $/€ exchange rate Explanation: B) Put options o er an insurance type protection. Pope can purchase out-of-the-money put options, for example, which will bene t if the Euro depreciates.If the value $/€ declines, the increase in the put option’s value will compensate Popefor the loss the Euro depreciation causes to the portfolio. If the Euro remainsunchanged or appreciates, Pope can allow the puts to expire like an insurance policythat never needed to be used 8. Compared to options on currencies, futures contracts on currencies o er a: A)more perfect hedge at a higher initial cost. B)more perfect hedge at a lower initial cost. C)less perfect hedge at a lower initial cost Explanation: B) Futures have a negligible initial cost and the symmetric payo of the futures usually o ers a more perfect hedge than that o ered by a put contract, whichhas a premium that is an upfront cost 9. Phil Johnson, CFA, is a portfolio manager in the United States and manages a portfolio denominated in yen. Johnson has been using forward contracts on the yen tohedge this portfolio, but now he is considering using put options. Johnson:

A)may choose to use put options if he wishes to more perfectly hedge his portfoliothan was possible with the forward contracts. B)may choose to use put options if he wishes to allow for upside potential oncurrency changes while hedging downside risk. C)may choose put options if he wishes to lower the upfront hedging costs from whathe incurred using forward contracts Explanation: B) Put options o er the type of bene t described in the answer. They allow the upside potential of a yen appreciation, but there is a cost at the initiation ofthe hedge not incurred with forward and futures contracts 10. Phil Johnson, CFA, is a portfolio manager in the United States and has implemented a delta hedge strategy using put contracts on his ₤ 2,000,000 security portfolio. The delta is -0.667, and Johnson used this value in composing his delta hedge using putcontracts. The value of the pound increases from $2.00/ ₤ to $2.10/ ₤ . If the delta hedge works perfectly, then the change in the value of each put on each British poundwill be closest to a/an: A)decrease of $0.07. B)increase of $0.07.C)decrease of $0.03 Explanation: A) In dollar terms, the change in the exchange rate causes the value of the portfolio to increase by 5% or $200,000. Johnson would have purchased puts on ₤ 2,000,000. If the hedge is working perfectly, the put on each British pound would decline by approximatly $0.067, so $0.07 is the closest answer.Delta = Change in option premium / Change in exchange rateSo, delta × change in exchange rate = change in option premium-0.667 × $0.10 = -$0.07

11. Phil Johnson, CFA, is a portfolio manager in the United States and has been using a delta hedge strategy using $/€ put contracts on his €5,000,000 security portfolio.Johnson estimates the delta of the put contract to be -0.40, and Johnson used thisvalue in composing his delta hedge. The $/€ exchange rate decreases from $1.25/€ to$1.2/€. The price of the put per Euro increases by $0.01. Based on this information,Johnson’s net position would: A)decline by $375,000. B)decline by $125,000. C)increase by $125,000. Explanation: B) Johnson would have purchased -1 / -0.4 = 2.5 put contracts for each Euro. The value of the portfolio would have declined by $250,000 = (1.25 −1.2)($/€)(€5,000,000). The value of the put contract position will increase by $125,000 =($0.01)(5,000,000)(2.5). Thus, the net change is a decline of $125,000 12. Jill Pope, CFA, is a portfolio manager in the United States and has been using a delta hedge strategy using $/yen put conracts on her 10,000,000 yen security portfolio.The delta is 0.80. Other things equal, in dollar terms, a 0.100% decrease in the $/yenexchange rate would produce a: A)0.1% decrease in the security portfolio and a 0.125% increase in each putpurchased. B)0.1% decrease in the security portfolio and a 0.080% increase in each putpurchased. C)0.1% increase in the security portfolio and a 0.080% increase in each putpurchased. Explanation: B) The decrease in the $/yen exchange rate will lower the value of the portfolio in dollar terms because each yen will be able to be converted to fewerdollars. The delta of an option is de ned as its value change relative to the value

change of the underlying. Thus, the options will increase by 0.8 times the percentdecline in the $/yen exchange rate 13.1 Bill Bender is a currency trader for International Investing Inc. International’s portfolio managers specialize in nding attractive international investments for U.S.investors. Bender reviews these transactions and determines whether to hedge awaysome of the risk, then takes the appropriate hedging action.Tonight he will speak to several hundred students taking investment classes at a localcollege, discussing strategies for hedging currency risk. While eating lunch, heprepares the following talking points:Options can be used to both directly and indirectly hedge currency risk. Futures cando the same.Direct hedging of the principal with futures allows investors to hedge away risk, butnot to participate in any currency gains.A minimum-variance hedge is better than a simple hedge because it accounts fortranslation risk.To avoid basis risk, investors should make sure their futures contracts mature at theend of the asset holding period. The analysts were busy this morning, and upon his return from lunch, Bender had astack of proposed trades to review.The rst transaction involves a series of long and short equity trades on a variety offoreign markets. While the trades generally wash out market risk, they make noallowance for currency uctuations. The pro t margin on such strategies can be low,so Bender must keep costs to a minimum. Bender creates a strategy to hedge awaymuch of the risk.Another analyst wants to take long positions in a variety of European small-capcompanies. While the analyst is con dent that the stocks will deliver returns superiorto other European small-caps, he is concerned that decreases in the euro will erodethe returns for U.S. investors. The analyst has provided Bender with the following data:Portfolio value: €15 million.Expected 12-month return: 26%.

Current exchange rate: $1.56 per euro.Expected exchange rate in 12 months: $1.51 per euro.Euro put premium: $0.065.Delta: -0.58. To compensate for this problem, Bender decides to use a currency delta hedge.Bender then reviews another proposed transaction, the purchase of $10 million dollarsof municipal-bond issue in Transylvania. The bonds pay 12 percent because thecountry’s credit rating is fairly weak. But the Transylvania analyst believes a recentregime change should stabilize the government, and the new leaders will take everyprecaution needed not to default on the bonds. Bender likes the investment, but hasno idea what e ect the recent coup is likely to have on Trannsylvanian currency, so hedecides to fully hedge the principal and returns for the rst year of the investment.One analyst, Helen Carr, has asked for Bender’s assistance with a matter not related tocurrency hedging. Carr is not satis ed with the returns of her emerging-marketsmutual fund. Her returns are not well correlated with the returns of the Europe,Australia, Far East Index.Bender meets with Carr to discuss the bene ts of emerging-market investments ingeneral. Carr said it took several years to convince International Investments of thebene ts of emerging-market investing, allowing that company executives put forthsome compelling arguments for keeping out of such markets.After Bender and Carr get to the speci cs about how Carr can boost her returns,Bender suggests that she increase her exposure to small-cap emerging-market stocks.He says the purchase of such stocks will have several e ects:Increasing the portfolio’s return potential without sacri cing liquidity relative tolarge-cap emerging-markets stocks.Decreasing the portfolio’s correlation with the Europe, Australia, Far East Index.Making it easier to boost sector diversi cation relative to large-cap emerging-marketsstocks.Increasing the research complexity relative to large-cap emerging-markets stocks.Assuming currency uctuation and return expectations prove accurate and the priceof a put option rises by $0.036 over the next 12 months, how many put options mustBender buy or sell a year from now to hedge the position?

A)Buy 6,724,138 options.B)Sell 5,028,736 options. C)Buy 387,931 options Explanation: C) To create the currency delta hedge, Bender must purchase the following put options: −1 / delta × portfolio value = 25,862,069 puts. Then we mustcalculate how many options to buy or sell a year from now. New delta = change in putoption value / change in exchange rate = ($0.036) / (−$0.05) = −0.72. −1 / delta ×portfolio value = number of options needed to hedge. −1 / −0.72 × €15,000,000 × 1.26 =26,250,000 puts, or 387,931 more than the current holdings. 13.2 Which of Bender’s statements about small-cap emerging-markets stocks is least accurate? That they will: A)decrease the portfolio’s correlation with the Europe, Australia, Far East Index.B)make it easier to boost sector diversi cation relative to large-cap emerging-marketsstocks. C)increase the portfolio’s return potential without sacri cing liquidity relative tolarge-cap emerging-markets stocks. Explanation: C) Small-cap emerging-markets stocks are likely to boost returns, but they are also considerably less liquid than large-cap emerging-markets stocks. Bothremaining statements are accurate. 13.3 To accomplish his goals regarding the Trannsylvania investment, Bender should: A)sell $10 million worth of futures contracts.B)buy $11.2 million worth of futures contracts. C)sell $11.2 million worth of futures contracts.

Explanation: C) To hedge currency risk on a foreign bond purchase, a trader could sell currency futures. In this case, a $10 million investment should be worth $11.2 millionover a year. To fully hedge the principal and returns, Bender must sell futurescontracts equal to the value of the principal plus the interest return, or $11.2 million. 13.4 Which of the following arguments against investing in emerging markets is least convincing? A)Over most of the last 20 years, annualized returns for emerging markets laggedthose of U.S. investments.B)Over time, the correlation of emerging markets and that of developed markets islikely to increase. C)Emerging-markets stocks tend to lower returns and boost risk for globalportfolios during bull markets in U.S. stocks Explanation: C) Emerging-markets stocks tend to lower returns and add risk during U.S. bear markets – they tend to boost returns in bull markets. The other two concernsare legitimate. 13.5 Which of Bender’s talking points is least accurate? A)Options can be used to both directly and indirectly hedge currency risk. Futures cando the same. B)A minimum-variance hedge is better than a simple hedge because it accounts fortranslation risk. C)Direct hedging of the principal with futures allows investors to hedge away risk, butnot to participate in any currency gains. Explanation: B) Simple hedges account for translation risk, while a minimum-variance hedge also addresses economic risk. The other statements are accurate.

13.6 To hedge away the basis risk for the long-short equity investment, Bender’s best option is a strategy: A)starting with options on the relevant foreign currencies. B)starting with a regression of U.S. returns of foreign currency futures. C)hedging the principal. Explanation: B) To correctly perform a cross-hedge, Bender should start with regression analysis of currency returns. A hedge of the principal won’t address thecross-currency issues. Put options may be an e ective hedge, but purchasing thatportfolio insurance requires up-front costs. If minimizing costs is key, options are notthe answer. 14. When adding exposure to equities in a foreign market to your portfolio, which of the following strategies would o er the lowest amount of currency risk? In: A)the foreign derivatives market going short call options on an index on the foreignmarket. B)your domestic derivatives market going long call options on an index on theforeign market. C)your domestic derivatives market going long call options on an index on yourdomestic market. Explanation: B) You would want to go long call options on the foreign index. You can choose to purchase calls on the index and would only have the initial premiumcommitted (i.e., exposed to translation risk). Further, you may nd the desired calloptions traded on your domestic exchange. In this case, translation risk is totallyeliminated, because the premiums are stated in your domestic currency. 15. When adding exposure to equities in a foreign market to your portfolio, which of the following strategies would o er the lowest amount of currency risk? In:

A)the foreign futures market going short index futures on an index on the foreignmarket. B)your domestic futures market going long index futures on an index on the foreignmarket. C)your domestic futures market going long index futures on an index on your domesticforeign market. Explanation: B) You would want to go long futures on the foreign index. You can choose to go long foreign equity index futures and would only have the initial margincommitted (i.e., exposed to translation risk). Further, you may nd the desired indexfuture traded on a domestic exchange. In that case, currency exposure is totallyeliminated, because prices (including margins) are stated in your domestic currency 16. Jill Pope, CFA, has been managing a stock portfolio denominated in a foreign currency and has set a particular nominal return goal for the portfolio. She wishes toinvestigate ways to achieve the goal while lowering the currency risk. Which of thefollowing strategies is most appropriate? A)Decreasing the duration of the stock portfolio. B)Increasing the beta of the stock portfolio. C)Decreasing the beta of the stock portfolio. Explanation: B) By increasing beta, Pope has increased the risk exposure to the local market factors relative to the currency exposure. Pope will be able to achieve a givenreturn objective with less currency risk. Since it is a stock portfolio, duration is notrelevant 17. In the management of currency exposure, the one approach that would most likely explicitly include a benchmark for returns on currency positions would be associatedwith:

A)an overlay approach. B)a separate asset allocation approach. C)a balanced mandate approach. Explanation: B) There are three primary approaches to managing the currency exposure in an international portfolio.Balanced Mandate: Under a balanced mandate approach, the investment manager isgiven total responsibility for managing the portfolio, including managing the currencyexposure. The manager follows the guidelines of the investor’s IPS, which will specifywhether the portfolio is to be benchmarked and the degree to which translation riskmust be hedged.Currency overlay: The currency overlay approach still follows the IPS guidelines, butthe portfolio manager is not responsible for currency exposure. Instead a separatemanager, who is considered an expert in foreign currency management, is hired tomanage the currency exposure within the guidelines of the IPS. That is, the portfolio,including the currency exposure, is managed by two managers to adhere to the IPSguidelines.Separate asset allocation: When currency is considered a separate asset, it ismanaged as if it were a totally separate allocation given to a separate manager andmanaged under its own, separate guidelines. E ectively, this is a currency play withan absolute return benchmark 18. Rob Johnson, CFA, manages a large portfolio of international assets for a client. He and the client had agreed upon a well-de ned IPS, which speci ed that an outsideexpert would manage the currency risk as part of the overall portfolio strategy.Recently Johnson and the client changed the IPS so that the expert manages currencypositions using a strategy distinct from the security portfolio and distinctbenchmarks. The move that Johnson and the client have agreed upon would be bestdescribed as moving from: A)an overlay approach to a separate asset allocation approach. B)a separate asset allocation approach to an overlay approach.

C)a balanced mandate approach to a currency overlay approach Explanation: A) There are three primary approaches to managing the currency exposure in an international portfolio.Balanced Mandate: Under a balanced mandate approach, the investment manager isgiven total responsibility for managing the portfolio, including managing the currencyexposure. The manager follows the guidelines of the investor’s IPS, which will specifywhether the portfolio is to be benchmarked and the degree to which translation riskmust be hedged.Currency overlay: The currency overlay approach still follows the IPS guidelines, butthe portfolio manager is not responsible for currency exposure. Instead a separatemanager, who is considered an expert in foreign currency management, is hired tomanage the currency exposure within the guidelines of the IPS. That is, the portfolio,including the currency exposure, is managed by two managers to adhere to the IPSguidelines.Separate asset allocation: When currency is considered a separate asset, it ismanaged as if it were a totally separate allocation given to a separate manager andmanaged under its own, separate guidelines. E ectively, this is a currency play withan absolute return benchmark 19. Jill Pope, CFA, manages a large portfolio of international assets for a client. She and the client had agreed upon a well-de ned IPS, which speci ed that Pope wasresponsible for managing currency exposure as one of the risks of the portfolio.Recently Pope and the client changed the IPS so that they now have hired a separatemanager, who is an expert in currency risk, and that manager will be responsible forcurrency risk. The move that Pope and the client have agreed upon would be bestdescribed as moving from: A)an overlay approach to a balanced mandate approach. B)a balanced mandate approach to a currency overlay approach. C)an overlay approach to a separate asset allocation approach. Explanation: B) There are three primary approaches to managing the currency exposure in an international portfolio.

Balanced Mandate: Under a balanced mandate approach, the investment manager isgiven total responsibility for managing the portfolio, including managing the currencyexposure. The manager follows the guidelines of the investor’s IPS, which will specifywhether the portfolio is to be benchmarked and the degree to which translation riskmust be hedged.Currency overlay: The currency overlay approach still follows the IPS guidelines, butthe portfolio manager is not responsible for currency exposure. Instead a separatemanager, who is considered an expert in foreign currency management, is hired tomanage the currency exposure within the guidelines of the IPS. That is, the portfolio,including the currency exposure, is managed by two managers to adhere to the IPSguidelines.Separate asset allocation: When currency is considered a separate asset, it ismanaged as if it were a totally separate allocation given to a separate manager andmanaged under its own, separate guidelines. E ectively, this is a currency play withan absolute return benchmark