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CFA Level III · Cheat Sheet

Derivatives & Currency

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DERIVATIVES & CURRENCY – CHEAT SHEET

CURRENCY MANAGEMENT: THE HEDGING DECISION

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STATIC vs. DYNAMIC HEDGING

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CURRENCY ALPHA SOURCES

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FORWARD CONTRACTS & HEDGING MECHANICS

Key Formula: Forward premium/discount ≈ interest rate differential (r_foreign − r_domestic)

Hedging Cost:

  • If foreign rates > domestic rates → forward discount → hedging costs positive carry
  • If domestic rates > foreign rates → forward premium → hedging provides positive carry

Rolling a Hedge: Close expiring contract, enter new one at current forward rate. Repeat cost if currency remains at discount.

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CROSS-CURRENCY & PROXY HEDGING

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Proxy Hedge Ratio (minimum variance): $$\text{Hedge Ratio} = \frac{\rho_{A,B} \times \sigma_B}{\sigma_A}$$

Where A = proxy currency, B = target currency. Imperfect hedge; correlation critical.

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CURRENCY OPTIONS & DYNAMIC STRATEGIES

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When to Use Options vs. Forwards:

  • Forwards: Full certainty on rate; no premium; directional hedge (long or fully short).
  • Options: Asymmetric payoff; higher cost; retain upside; useful when FX move is uncertain.

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COVERED INTEREST RATE PARITY (CIP) & ARBITRAGE

Formula: $$F = S \times \frac{1 + r_{\text{domestic}}}{1 + r_{\text{foreign}}}$$

If violated, riskless arbitrage exists:

  • Borrow domestic, exchange at spot, invest foreign, sell forward → locked-in profit if CIP fails.
  • In normal markets, CIP holds tightly (especially for major currencies).

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COMMON MISTAKES & DECISION TRAPS

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QuestionAnswer
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 definitionFixed % of FX exposure to hedge on an ongoing basis (typically 50–100%). Rebalance and roll forwards periodically.
DimensionStatic (Passive)Dynamic (Active)
MethodFixed % hedge; roll forwards at maturityAdjust hedge ratio based on FX views/market conditions
Upside CaptureLimited; fully hedged to target ratioHigher if FX view is correct
Downside RiskPredictable; remains at target ratioRisk of under-hedging if FX depreciates unexpectedly
Value-AddRemoves FX risk; no alphaRequires accurate FX forecasts to generate alpha
CostLower (fewer adjustments)Higher (more transaction costs, active management)
StrategyHow It WorksRisk
CarryBorrow low-rate currency, invest high-rate currency. Earn rate differential.Adverse FX move offsets carry gain (tail risk in stress)
MomentumTrade in direction of recent currency trendsReversal risk; trends can break suddenly
ValueBuy undervalued currencies (vs. PPP, REER models)Mean reversion is slow; valuation can persist
InstrumentWhen UsedKey Risk
Direct ForwardLiquid, major currency pairsNone (assuming counterparty is sound)
Proxy HedgeIlliquid or restricted currency; correlate 3rd currencyCorrelation breakdown in stress → hedge fails when needed most
Non-Deliverable Forward (NDF)Emerging markets w/ capital controlsCounterparty risk + basis risk (onshore ≠ NDF rate)
InstrumentPayoffUse Case
Put Option (sell FX)Floor on FX downside; pay premiumProtect portfolio if FX depreciates
Call Option (buy FX)Cap on FX upside; pay premiumSpeculative: bet on FX appreciation
Risk ReversalBuy OTM put + sell OTM callCollar; potentially zero cost if premiums equal
SeagullCollar + sell deeper OTM putLower premium cost but adds downside below strike
TrapCorrect 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.
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EXAM-FOCUSED CHECKLIST

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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