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FRM 2008 Practice PIII question 31 - Foreign Bonds

fullofquestions

New Member
QUESTION
Wallace, an emerging market bond trader, is holding a USD 5 year Malaysian corporate bond in his book.
He has made enough profit from this bond position and wishes to lock in the profit (full hedge) without
selling it. Which is the best option for Wallace below?
a. Buy protection with a USD 5 year Malaysian bond.
b. Buy protection with a USD credit default swap on the Malaysian corporate bond.
c. Buy protection with a USD 5 year US Treasury government bond and short a USD credit default swap
on the Malaysian corporate bond.
d. Buy protection with a USD 5 year Ringgit Malaysia government bond and USD short a credit default
swap on the Malaysian corporate bond.

Answer: c
a. Incorrect. Shorting government bond only does not hedge the credit spread risk.
b. Incorrect. Shorting the CDS only hedges the credit spread risk. Not the systematic risk of the
government yield movement.
c. Correct.
d. Incorrect. Local government bond is locally denominated, thus can not be use to hedge out
currency risk.


For a full hedge, Wallace wants to protect from default and credit deterioration. Since all of the options are USD denominated, how come there is mention of currency risk(explanation to choice d)?
I see clearly that the USD CDS on the Malaysian corporate bond will protect against a default, but only when you long the CDS. So the first question is, why does Wallace want to short the CDS?
Secondly, in order to protect from credit deterioration, I would think that a USD Malaysian government bond would do the trick, hence, choice d looks correct. Why is the US Treasury bond the correct choice? I see that the US Treasury bond will hedge interest risk but I believe Wallace wants to hedge interest risk in Malaysia. Everything is USD denominated so I don't see the need for the US Treasury.

Perhaps I've got this all wrong. Could someone clarify my assumptions? Perhaps with an explanation to the original position I won't need to receive an explanation of the answer. Thanks
 

hsuwang

Member
I was just done with the 08' practice and I have to say I agree with you with the doubts you have about this question and also many others too...
 

spenserzhou

New Member
Could that the reason be, the cds spread has already priced the sovereign risk of the bond. hence it's not good to use the malaysia bond but the us treasury bond, which imply minmal sovereign risk? So the point is not the usd-issue, demonstrated in the answer.....
 

fullofquestions

New Member
Anyone?

The question does give you a hint that you want a full hedge. The answer then hints that you want to hedge:

1. Credit Spread Risk - This you can resolve by shorting a USD CDS on the Malaysian bond. HUGE red flag here, if corporate bond defaults, then you pay in case of default. While you are hedging credit spread risk you are now taking on more risk. This I believe to be wrong, at least with the information given.

2. Systematic Risk of the government yield - therefore buy a gov't bond. got it

3. Currency - therefore buy USD denominated US gov't bond. got it.
 

David Harper CFA FRM

David Harper CFA FRM
Staff member
Subscriber
FoQ -

This question just looks simply wrong to me..."short the CDS" isn't right ... selling protection is long the bond. Confusing....

David
 
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