The World Ecosystem Consortium (WEC) pension trust holds $100 million in long-term U.S. Treasury bonds. To reduce interest rate risk, you, as an independent adviser to the WEC, suggest that the trust diversify by investing $30 million in German government bonds (bunds) for six months. You point out that a fixed-currency futures hedge (shorting a fixed number of contracts) could be used by WEC's pension trust to protect the $30 million in bunds against exchange rate losses over the six months.
Explain how a fixed-currency futures hedge could be constructed for the WEC trust by shorting currency futures contracts to protect against exchange rate losses.
Describe one characteristic of this hedge that WEC's investment committee might deem undesirable.
Interest Rate Risk and FX Risk
Interest rates and prices move inversely. To hedge against rising interest rates, you would establish a short duration position - and vice versa. This is related to FX risk in the sense that interest rate parity holds. As domestic interest rates move, foreign interest rates and/or exchange rates must move to ensure no arbitrage is possible on spot or forward markets.
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fromChapter 3 / Lesson 6
Interest rate risk is really the risk of two different events (price reduction and reinvestment rate reduction) caused by a change in interest rates. Interest rate risk affects bond investments, but the good news for bond investors is that it can be mitigated or eliminated.