Rika Björk runs the currency overlay program at a large Scandinavian investment fund, which uses the Swedish krona (SEK) as its reporting currency. She is managing the fund’s exposure to GBP-denominated assets, which are currently hedged with a GBP 100,000,000 forward contract (on the SEK/GBP cross rate, which is currently at 10.6875 spot). The maturity for the forward contract is December 1, which is still several months away. However, since the contract was initiated the value of the fund’s assets has declined by GBP 7,000,000. As a result, Björk wants to rebalance the hedge immediately.
Q. To rebalance the SEK/GBP hedge, and assuming all instruments are based on SEK/GBP, Björk would buy:
- GBP 7,000,000 spot.
- GBP 7,000,000 forward to December 1.
- SEK 74,812,500 forward to December 1.
Solution
B is correct. The GBP value of the assets has declined, and hence the hedge needs to be reduced by GBP 7,000,000. This would require buying the GBP forward to net the outstanding (short) forward contract to an amount less than GBP 100,000,000.
A is incorrect because to rebalance the hedge (reduce the net size of the short forward position) the GBP must be bought forward, not with a spot transaction.
C is incorrect because the GBP must be bought, not sold. Buying SEK against the GBP is equivalent to selling GBP. Moreover, the amount of SEK that would be sold forward (to buy GBP 7,000,000 forward) would be determined by the forward rate, not the spot rate (7,000,000 × 10.6875 = 74,812,500).
