What does it mean, "Hedging into each portfolio's base currency"?

CFA Level III Fixed Income
#1

HI,

IN Study session 12, Reading 24, practice question no. 27.

The question talks about “hedging into each portfolio’s base currency”

And in the answer to the question:

They provide the following ->

For hedging US, UK, and Mexican bonds into Euros for six months the calculation is:

USD into EUR: (0.15% – 1.40%)/2 = –0.625%

GBP into EUR: (0.15% –0.50%)/2 = –0.175%

MXN into EUR: (0.15% – 7.10%)/2 = –3.475%

Where 6 months Libor for MExico is 7.1%, Euro is 0.15%, UK is 0.5% and US is 1.4%

(Note that a negative number is a cost while a positive number would be a benefit.)

Can someone explain what does “hedging into each portfolio’s base currency”?

Thanks!

#2

If you have a portfolio denominated in, say, GBP, and you invest in a CAD-denominated bond, then hedging into the portfolio’s base currency would be hedging the CAD/GBP exchange rate so that your returns in GBP are the same as your returns in CAD.

#3

Base…Basement…it’s on the bottom.

#4

Unless, it’s indirect quotation. :slight_smile:

Hedging the basis currency, simply means reducing the exposure to certain key risk factor which is a foreign currency in this situation.

You may take direct hedging by shorting the long primarily exposure in foreign currency (e.g by entering into Forward contract) or take a cross hedge by shorting another currency which is closely correlated to that particular foreign currency.

You might reasonably decide to not hedge at all and just wait that everything to revert to the mean. :slight_smile:

#5

sounds like a solid plan lol

another point is, and what i dislike about this method of conveying words is ive always been used to looking at it as Domestic/Foreign. Keeps it simple but I understand in certain situations it can change.

#6

Properly, you’ve described a proxy hedge, not a _ cross _ hedge.

In a proxy hedge, you use your domestic currency and another currency with a strong (price) correlation with the foreign currency.

In a cross hedge you use the foreign currency and another currency with a strong (price) correlation with your domestic currency.

#7

Same fashion. Same folklore. Doesn’t matter how you call that in academic speeches. Anyway, thanks for your comment.

#8

What’s irritating is that in one Level III reading it uses the terms correctly, while in another reading it uses them interchangeably (but has a footnote that says that they’re different).

Sigh.