Can someone please provide more guidance as to why the answer to #23 is sell euros and by dollars? The answer states, “the Forward rates for both the dollar and the euor fully reflect the interest rate differentials as expected by interest rate parity. As such, forwards reflect that the dollar is expected to appreciate relative to the pound and the euro to depreciate relative to pound. Kingsbridge’s view, however, is that the dollar will appreciate more than the forward implies and the euro will depreciate more than the forward implies. The result in actively managing the portfolio is that Kingsbridge should hedge the the euro bonds into the dollar.”
This is an area I am weak at with respect to fixed income, if anyone can explain this with the numbers used in the exhibit I would greatly appreciate it. Thank you.
I don’t have it in front of me, but since the investor expects the dollar to appreciate more than implied by the forward rate, then that means the principal of the investment (let’s say EUR 100,000) would get him _ less _ dollars by that time, so he locks in a certain amount of dollars on the forward rate, expecting that the Euro will depreciate more than that, and buy less dollars for him.
Remember that any foreign investment is the local return and the foreign currency return. You hedge when the foreign currency return is expected to depreciate as much, or more than implied by the forward rate, and the opposite is true.
You currency have dollar bonds. This is a good thing. So you wouldn’t hedge, as you think you will get more.
You get alpha from currency management, this means you are taking positions not only to hedge, but making money.
Right now I can lock in .6137 BP per 1 dollar. I EXPECT to be able to sell a dollar for even more than the future, that is .6173. So I’m BUYING dollars at .6137, and will be able to SELL them in the spot for .6173. Another way to look at it, the expected future rate is GREATER than the Forecast, so I want to buy something low and sell high.
The BP is DEPRECIATING to the dollar, and is DEPRECIATING even more expected then what the future gives us.