4. Hedging Currency Risk in Foreign Equity Investing (intermediate). Cougar Investments holds 10,000 shares of Embraer and 25,000 shares of Bank Itau, currently worth BRL 100 and BRL 40, respectively. Both stocks have an expected return in Brazilian reals of 12 percent for 2012 with a similar level of risk at 15 percent.

Embraer is a leading exporter of aircraft and the correlation between its share price in reals and the Canadian dollar is = –0.50, whereas Bank Itau is primarily oriented to the Brazilian market and shows a correlation with the exchange rate of +0.65.

a. What is the risk faced by Cougar Investments on its Brazilian stock holdings?

b. Given a widely anticipated 15 percent depreciation of the real against the Canadian dollar, would you advise Cougar Investments to hedge its currency exposure?

Explain your rationale.

c. One-year forward contracts on the BRL trade at a 7.5 percent discount. What would be your expected return on either investment with or without a currency hedge?

d. Would consideration of the correlation between Embraer and Bank Itau’s BRL return change your recommendations?