A US based intl bond fund manager is trying to determine the best currency strategy under the following circumstances: Expected bond return in Korea = 10% Short term interest rates in Korea = 7% Expected appreciation of Korean won relative to USD = -3% Short term US interest rates = 5% The fully hedged expected currency return is: 0% 4% 7%
0%
Hmm… that is odd… Local Market Return = 10% in Won If hedged with forward contract, we lock in a Won depreciation by (7%-5%) = 2% depreciation. That would suggest a fully hedged return of 10% + (-2%) = 8% vs. an unhedged return of 10% + (-3%) = 7% Anyone disagree? It does look like Stalla is wrong. How do they explain their answer? (which is presumably 7%, yes)
bchad - it only asks for currency return happyking, how 0%? Thats right but I thought you would lock in the forward currency or discount, therefore using currency forwards you would lock in the 2% depreciation of the won?
The fully hedged expected CURRENCY return ? I don’t know what does CURRENCY return mean !
The Stalla answer is: If fully hedged, the expected return should be zero assuming the hedge is effective. I think it should be -2%. Help?
If you assume that all currency risk is hedged, the return just based on currency fluctuation has to be 0%! You will just be left with the return on the asset in local terms. If this is what they were asking for, then the answer would be 8% as bchad suggests above. The only way this isnt true is if you construct your hedge inappropriately.
That’s bizarre. Hedging means that currency RISK = 0, not currency RETURN = 0. When you hedge, you lock in a currency loss of 2% in order to eliminate currency risk.
How does hedged currency imply 0% return? Aren’t you just locking in forward discount/premium? PS- willispierre the question only wants currency return not R(DC)
I’m with bchadwick here. I would have said 8%.
I looked at the difference between 7 & 8; because there’s an extra +1% to be had if you hedge now which is fully attributable to currency effects… This is stupid. So what are we concluding?
Trick question. Fully hedged currency return is always 0 because you are fully hedging the currency and eliminating currency return. The hedged return on the bond is 8%. That is a very stupid question on Stalla’s behalf.
I wouldn’t stress about this question for exam day. CFAI is usually much clearer than Stalla in terms of the questions they ask. I still think that the currency RISK is zero, not the currency return. The currency return is -2%, you just have locked it in ahead of time.
yeah, you are right…was running on fumes last night when i responded to this…