Qasim Omer works as a consultant on currency management at Linda Asset Management headquartered in Canada. His role requires Qasim to provide consultation to portfolio and fund managers within Linda Asset Management as well as external clients (including high net-worth individuals and institutional investors).

Samantha Jones who is an equity portfolio manager at Linda approached Qasim in September seeking advice to manage 5,000,000 position in U.K. equity security. Samantha has just purchased this U.K. equity security for her portfolio. Her expectations were that the U.K. equity security will earn relatively higher return than similar Canadian equity securities, however, she feared a weak relative to C$ over the period. Qasim advised that Samantha hedge 100% of the exposure to manage this risk.

Samantha immediately executed the hedge by entering into enough December futures contracts to sell 5,000,000 for Canadian dollars at a futures exchange rate of C$1.75/. At the time, the spot exchange rate was C$1.80/.

After one month, the value of the U.K. equity is 5,200,000 with a spot exchange rate of C$1.70/ and future priced at C$1.65/. Samantha is interested to know the payoff and asks Qasim to calculate the net profit or loss on the hedged U.K. stock position. Qasim made the following statement to Samantha before initiating his analysis:

The return on a hedged stock will differ from the stock return achieved in foreign currency for the following reasons: foreign exchange transaction costs, stock price volatility, and the interest rate differential.

Tony Abbott is an international equity portfolio manager at Linda who is expecting that over the next two years C$ will appreciate against all the other six foreign currencies in his portfolio. Tony approached Qasim to seek advice on hedging these exposures. Qasim suggests that Tony should directly hedge the currency exposures of major currencies i.e. euro, pound and yen while the other 3 minor currencies should be cross-hedged using any of the three major currencies (euro, pound or yen). Correlation will be used to determine the hedging currency for the minor currencies i.e. the currency with the highest correlation will be used to hedge the minor currency. Qasim substantiated this strategy with the following three facts:

Fact 1. Currency futures and forward contracts are actively traded only for major currencies.

Fact 2. In portfolios with assets in many currencies, the residual risk of each currency is partly diversified away.

Fact 3. Changes in the exchange rates for major currencies are often closely related to changes in other currencies.

Qasim advises Tony that the hedges should be implemented with short term futures with maturities of up-to 3 months. He justified the use of short term futures by giving the following statement:

Short-term futures contracts are preferable to long-term futures contracts because they offer greater liquidity and lower transaction costs.

An institutional investor of Linda, Union Pension Fund, requires to hedge foreign currency exposure within the pension funds mix of assets. The fund approaches Qasim for advice on hedging. Qasim considers the following three factors before giving recommending any strategic benchmark hedge ratio to the fund:

Factor 1. Asset types held by the plan.

Factor 2. Forecasted short-term changes in exchange rates.

Factor 3. Transaction and interest differential costs of hedging.

Required:

1. Discuss the Fact (out of the 3 Facts) which is the least supportive of Qasims recommended hedge structure to Tony. Discuss all the 3 Facts in detail.