International Financial Management 6th Edition by Sanjiv Eun, Cheol Resnick, Bruce Sabherwal

Exercise 16

The Glover Scholastic Aid Foundation has received a €20 million global government bond portfolio from a Greek donor. This bond portfolio will be held in euros and managed separately from Glover's existing U.S. dollar-denominated assets. Although the bond portfolio is currently unhedged, the portfolio manager, Raine Sofia, is investigating various alternatives to hedge the currency risk of the portfolio. The bond portfolio's current allocation and the relevant country performance data are given in Exhibits 1 and 2. Historical correlations for the currencies being considered by Sofia are given in Exhibit 3. Sofia expects that future returns and correlations will be approximately equal to those given in Exhibits 2 and 3.
Exhibit 1. Glover Scholastic Aid Foundation Current Allocation Global Government Bond Portfolio Exhibit 2. Country Performance Data (in local currency) Exhibit 3. Historical Currency Correlation Table (1998-2003, weekly observations) a. Calculate the expected total annual return (euro-based) of the current bond portfolio if Sofia decides to leave the currency risk unhedged. Show your calculations.
b. Explain, with respect to currency exposure and forward rates, the circumstance in which Sofia should use a currency forward contract to hedge the current bond portfolio's exposure to a given currency.
c. Determine which one of the currencies being considered by Sofia would be the best proxy hedge for Country B bonds. Justify your response with two reasons.
Sofia has been disappointed with the low returns on the current bond portfolio relative to the benchmark-a diversified global bond index-and is exploring general strategies to generate excess returns on the portfolio. She has already researched two such strategies: duration management and investing in markets outside the benchmark index.
d. Identify three general strategies (other than duration management and investing in markets outside the benchmark index) that Sofia could use to generate excess returns on the current bond portfolio. Give, for each of the three strategies, a potential benefit specific to the current bond portfolio.