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Erich Reichmann, CFA, is a fixed-income portfolio manager with Global Investment Management. A recent increase in interest rate volatility has caused Reichmann and his assistant, Mel O'Shea, to begin investigating methods of hedging interest rate risk in his fixed income portfolio.
Reichmann would like to hedge the interest rate risk of one of his bonds, a floating-rate bond (indexed to LIBOR). O'Shea recommends taking a short position in a Eurodollar futures contract because the Eurodollar contract is a more effective hedging instrument than a Treasury bill futures contract.
Reichmann is also analyzing the possibility of using interest rate caps and floors, as well as interest rate options and options on fixed income securities, to hedge the interest rate risk of his overall portfolio.
Reichmann uses a binomial interest rate model to value 1-year and 2-year 6% floors on 1-year LIBOR, both based on $30 million principal value with annual payments. He values the 1-year floor at $90,000 and the 2-year floor at $285,000.
Reichmann has also heard about using interest rate collars to hedge interest rate risk, but is unsure how to construct a collar.
Finally, Reichmann is interested in using swaptions to hedge certain investments. He evaluates the following comments about swaptions.
* If a firm anticipates floating rate exposure from issuing floating rate bonds at some future date, a payer swaption would lock in a fixed rate and provide floating-rate payments for the loan. It would be exercised if the yield curve shifted down.
* Swaptions can be used to speculate on changes in interest rates. The investor would buy a receiver swaption if he expects rates to fall.
Based on the results from Reichmann's binomial interest rate model, the value of a 2-year, $30 million European put option on LIBOR with a floor strike of 6% is closest to:

Debbie Angle and Craig Hohlman arc analysts for a large commercial bank, Arbutus National Bank. Arbutus lias extensive dealings in both the spot and forward foreign exchange markets. Angle and Hohlman are providing a refresher course on foreign exchange relations for its traders. Unless indicated otherwise, Angle tells the traders to assume that real interest rates arc equivalent throughout the world.
Angle uses a three country example from North America to illustrate foreign exchange parity relations. In it, the Canadian dollar is expected to depreciate relative to the U .S . dollar and the Mexican peso. Nominal, one year interest rates in the United States are 7% and are 13% in Mexico. From this data and using the uncovered interest rate parity relationship, Angle forecasts future spot rates.
During their presentation, Hohlman discusses the effect of monetary and fiscal policies on exchange rates. He cites a historical example from the United States, where the Federal Reserve shifted to an expansionary-monetary policy to stimulate economic growth. This shift was largely unanticipated by the financial markets because the markets thought the Federal Reserve was more concerned with inflationary pressures. Hohlman states that the effect of this policy was an increase in economic growth and an increase in inflation. The cumulative effect on the dollar was unchanged, however, because, according to Hohlman, an increase in U .S . economic growth would strengthen the dollar whereas an increase in inflation would weaken the dollar.
Regarding U .S . fiscal policies, Hohlman states that if these were unexpectedly expansionary, real interest rates would increase, which would produce an appreciation of the dollar. But, Hohlman adds, an increase in the federal budget would encourage imports such that the overall short-run effect would be for a decrease in the value of the dollar.
Using this same historical example, Angle discusses capital flows and the effect on the balance-of-payments components. Angle makes the following statements:
Statement 1; Differences in real interest rates will cause a flow of capital into those countries with the highest available real rates of interest. Therefore, there will be an increased demand for those currencies, and they will appreciate relative to the currencies of countries whose available real rates of return are low.
Statement 2: The flow of foreign capital into U .S . investments, net of outflows of U .S . capital, is measured by the financial account. In the case of an expansionary fiscal policy, the financial account will increase and move towards a surplus.

Galena Petrovich, CFA, is an analyst in the New York office of TRS Investment Management, Inc. Petrovich is an expert in the industrial electrical equipment sector and is analyzing Fisher Global. Fisher is a global market leader in designing, manufacturing, marketing, and servicing electrical systems and components, including fluid power systems and automotive engine air management systems.
Fisher has generated double-digit growth over the past ten years, primarily as the result of acquisitions, and has reported positive net income in each year. Fisher reports its financial results using International Financial Reporting Standards (IFRS).
Petrovich is particularly interested in a transaction that occurred seven years ago, before the change in accounting standards, in which Fisher used the pooling method to account for a large acquisition of Dartmouth Industries, an industry competitor. She would like to determine the effect of using the purchase method instead of the pooling method on the financial statements of Fisher. Fisher exchanged common stock for all of the outstanding shares of Dartmouth.
Fisher also has a 50% ownership interest in a joint venture with its major distributor, a U .S . company called Hydro Distribution. She determines that Fisher has reported its ownership interest under the proportioned consolidation method, and that the joint venture has been profitable since it was established three years ago. She decides to adjust the financial statements to show how the financial statements would be affected if Fisher had reported its ownership under the equity method. Fisher is also considering acquiring 80% to 100% of Brown and Sons Company. Petrovich must consider the effect of such an acquisition on Fisher's financial statements.
Petrovich determines from the financial statement footnotes that Fisher reported an unrealized gain in its most recent income statement related to debt securities that are designated at fair value. Competitor firms following U .S . GAAP classify similar debt securities as available-for-sale.
Finally, Petrovich finds a reference in Fisher's footnotes regarding a special purpose entity (SPE). Fisher has reported its investment in the SPE using the equity method, but Petrovich believes that the consolidation method more accurately reflects Fisher's true financial position, so she makes the appropriate adjustments to the financial statements.
If Fisher Global decides to purchase only 80% of Brown and Sons, under 1FRS they will have the option to:

Chris Darin, CFA, works as a sell-side senior analyst and vice president for a large Toronto brokerage firm researching mainly hedge funds and alternative investments. Darin recently hired Simon Nielsen for the position of junior analyst at the firm. Although Nielsen does not have experience evaluating hedge funds, Darin hired him mainly for his previous experience at a discount brokerage firm and for his passion for the industry. Darin frequently mentors Nielsen on market trends, investment styles, and on risks inherent in alternative investment vehicles. In a recent conversation, Darin makes the following statements:
Statement 1: One way to measure hedge fund investment performance is through Jensen's alpha. A portfolio with negative Jensen's alpha would plot above the Security Market Line (SML).
Statement 2: Both the Sharpe ratio and Jensen's alpha can be used to measure risk-adjusted hedge fund returns. Oneof the advantages is comparability between the two methods since both calculate return relative to systematic risk.
Their conversation later shifts to discussing hedge fund classifications and how derivatives affect hedge fund performance measurement. Nielsen mentions that put options are often more advantageous than short selling in a market neutral strategy because of their asymmetric returns.
The following week Darin asks Nielsen to research potential problems and biases in hedge fund indexes and general risks inherent in investing in hedge funds. Nielsen compiles the information and presents the following findings:
1. One of the data problems in hedge fund indexes is that managers often do not disclose negative fund performance.
2. The historical performance of hedge funds that are recently added to an index is often added to the past performance of the index.
3. Long/short equity hedge funds are subject to equity market risk. This risk is typically greater than with equity market neutral or risk arbitrage funds due to the higher standard deviations and market correlations inherent in long/short funds.
4. Fixed income arbitrage funds are also subject to equity market risk. These funds are short Treasuries and long high-credit-risk bonds. In an economic downturn the short position in Treasuries provides a buffer against the long position and provides a net gain.
Finally, the two discuss the risk-free rate and various risk measures in hedge fund performance evaluation. Darin explains that even in market neutral strategies, the risk-free rate may not be an appropriate measure of fund performance. Nielsen does not understand and asks him to clarify. Darin further states that risk measures such as Value at Risk have several limitations as a risk measurement tool.
Nielsen's findings on long/short equity funds and fixed income arbitrage strategies, respectively, are: