Hi guys, this may be a stupid question but I really can’t wrap my head around it. I often come across this type of question: a foreign currency portfolio and you hedge away the FX risk with FX forward, what is the hedged return, provided domestic risk-free rate = 3% and foreign risk-free rate = 2%?
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In a recent official institute mock exam I took, in which the question states both the portfolio market return and FX risk are hedged, you simply earn the domestic risk-free rate of 3%. (Topic tested is from the Risk Management with Forward/Futures section). This makes intuitive sense to me, but…
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In the Schweser Practice Exam 1 AM section, it is also asking for hedged return, with the only difference being that portfolio market return (12%) is not hedged, only FX risk is hedged. The solution says the hedged return = 12% - 2% + 3% = 13%. It says “with hedging, you would lose the risk-free rate of the currency sold forward while gaining the risk-free rate of the currency purchased forward”. (Topic tested is from Asset Allocation, Currency Management Section)
My question is: why can’t I apply the logic in (2) to question (1)? In other words, why can’t the hedged return in (1) be calculated as -2% + 3% = 1%? After all, in (1), you are also selling the risk-free rate of foreign currency forward while purchasing the risk-free rate of domestic currency forward.
I am not sure which method I should use on the exam, if I’m given both risk-free rates and asked what the hedged return is. Would really appreciate any advice!