Consider a U.S. asset management firm that wishes to allocate €50,000,000 to the French stock… 1 answer below »

Consider a U.S. asset management firm that wishes to allocate €50,000,000 to the French stock market. This portfolio has a beta of 0.95. The spot exchange
rate is $0.8823 per euro. The foreign interest rate is 5.75 percent a year, and the domestic interest rate is 6.45 percent a year. A one-year forward
contract on the euro is priced at $0.8881. A stock index futures contract on the CAC 40 (French stock index) is priced at €46,390, with the multiplier
taken into account. The stock index futures contract has a beta of 1.05.

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A. Would the asset manager take a long or short position to hedge the equity market risk? Calculate the number of contracts needed.

B. Suppose the firm also wished to hedge the currency risk using a forward contract on the euro. What should be the notional principal of the forward
contract?

C. Assume that at the end of one year, the French market is up by 8 percent. The exchange rate is $0.8765 per euro, and the futures price is €47,550.
Calculate the return if

i. the portfolio is unheeded.

ii. only the equity position is hedged.

iii. both equity and currency risks are hedged.

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