Question 2

An American investor holds a British bond portfolio worth 100 million. The portfolio has a duration of seven. She fears a temporary depreciation of the pound but wishes to retain the bonds. To cover this risk, she decides to sell pounds forward. She has observed that the British government tends to adopt a leaning-against-the-wind policy. When the pound depreciates, British interest rates tend to rise to defend the currency.

(a) The investor runs a regression of variations in long-term British yields on percentage $/ exchange rate movements and found that it has a slope coefficient of 0.2. Interpret this regression result.

(b) The investor uses only forward currency contracts to hedge this risk and not bond futures contracts. What should be the optimal hedge ratio used by the investor if she wishes to reduce the uncertainty caused by exchange risk?

(c) List 3 factors that could make this hedge imperfect if the depreciation of the pound materialises. Elaborate on these factors.