# 2 EOC Questions Fixed Income Ch. 30

1. For problem #10, you are a British fund with US holdings. UK interest rate is 4.7% and US is 4%. US is expected to appreciate to UK by .4%. If you do nothing you will lose money because the currency appreciation is not enough to make up for the difference in yield. However it says if you hedge you will stand to make a greater return. I’m questioning how you make this hedge. The currency is already appreciating in your favor. If it was depreciating this would make sense to me. 2. For problem #20 and #21 you calculate the Hedged and unhedged returns. For hedged you take 10 yr government yield (Risk Premium) minus 1 year RFR. For unhedgeed you take 10 yr government yield (Risk Premium) and then account for currency change. I’m wondering how come for the hedged return you have to subtract out the RFR. After hedging against currency movement why can’t you just use the risk premium? Thanks.
1. You hedge with forwards. Locking in 0.7% based on IRP (if it holds). So hedging makes sense in this case. 2. Hedged return= return of foreign asset + Fwd premium/discount (based on IRP), so if you rearrange it, you get hedged return=domestic RFR + the return on foreign asset minus foreign risk free rate.
1. You hedge with forward contracts and the forward rate will be based on the interest rate differential. In this case, the interest rate differential is 0.7%. So, your hedged return if you are the British fund will be 4.7% (you can lock in a forward contract to guarantee a rate of return of 4.7%) If you do nothing (i.e., pick up 4% on the U.S. rate plus 0.4% on the U.S. currency appreciation) your return will only be 4.4%, less than the hedged return of 4.7%.

I’m still having a tough time wrapping my head around this. Since the difference in rates is .7%, doesn’t that mean the GBP will depreciate by .7%? Or does PPP not come into play here?

The U.S. currency should (if IRP holds) appreciate by 0.7%. In this case, the U.S. currency only appreciates by 0.4% so if you hedge you do better than not hedging. If the U.S currency appreciated by 1.5%, you would be better to do nothing (i.e., not hedge). That is why you hedge, to remove the volatility in the currency markets that screw with your returns when investing internationally.

thommo77 Wrote: ------------------------------------------------------- > The U.S. currency should (if IRP holds) appreciate > by 0.7%. In this case, the U.S. currency only > appreciates by 0.4% so if you hedge you do better > than not hedging. > > If the U.S currency appreciated by 1.5%, you would > be better to do nothing (i.e., not hedge). > > That is why you hedge, to remove the volatility in > the currency markets that screw with your returns > when investing internationally. Thanks, for some reason I thought it was a US investor holding GBP assets.

One more question. On number 7 it lists a non-callable bond as the asset funding a liability. And says the risks associated with the liability includes interest rate risk, contingent claim risk, and cap risk. How would a noncallable and seemingly non-floating security have contingent claim risk and cap risk?

Oh and thanks for clarity for the other question guys.

I set these up mechanically to check my work Line 1: Market says DC -.7 Line 2: Mgr says DC -.4 Line 1 - line 2 -.3 If line 3 is negative, you should hedge. Negative # means DC is cheap.

thepink , it could be putable bonds? i.e. remember these are liabilities not assets. If your creditor put the bonds back to you , that would be a contingent claim

thommo77 Wrote: ------------------------------------------------------- > The U.S. currency should (if IRP holds) appreciate > by 0.7%. In this case, the U.S. currency only > appreciates by 0.4% so if you hedge you do better > than not hedging. > > If the U.S currency appreciated by 1.5%, you would > be better to do nothing (i.e., not hedge). > > That is why you hedge, to remove the volatility in > the currency markets that screw with your returns > when investing internationally. If assets are in US dollars why would I hedge and settle for 0.4% appreciation if based on IRP I expect it to appreciate 0.7%. So how is hedging better?

I’m with hdave here, what am I missing? I thought I should only hedge if I think I can beat the market, so in this case, if I expect to only make 0.4% while IRP says I will make 0.7%, then shouldn’t I just stay put and go with the flow?

Well if your expectation is .4 appreciation and the market is saying .7, doesn’t it make sense to lock it in now in case it does end up at .4?

mp2438 Wrote: ------------------------------------------------------- > I’m with hdave here, what am I missing? > > > I thought I should only hedge if I think I can > beat the market, so in this case, if I expect to > only make 0.4% while IRP says I will make 0.7%, > then shouldn’t I just stay put and go with the > flow? If you expect the U.S. dollar to appreciate by 0.4%, and IRP says the U.S. dollar should appreciate by 0.7%, then you should HEDGE to lock in 0.7%. You hedge by entering into a forward contract that will be priced based on the interest rate differential of 0.7%.