It’s been a long study day for me and maybe I’m just mentally tired, but I’m having trouble with this seemingly easy question.
The expected (local currency) return on the bonds is 8.50%, and the 1-year risk-free yields are 1.3% in the United States and 4.6% in Australia. The spot exchange rate is USD0.6900/AUD1 and the one-year forward rate is USD0.6682/AUD1
If the Australian currency risk is fully hedged, the bond’s expected return will be closest to:
Because IRP holds in this case, I used the formula “ Domestic interest rate + (Local Market return – Foreign Interest Rate) “
1.3 + (8.5 – 4.6) = 5.2%
The answer takes the LMR and adds the forward discount. (.6682-.69 / .69 = - 3.16%)
8.5 + ( - 3.16) = 5.34%
Am I right to assume that the first formula (“ Domestic interest rate + (Local Market return – Foreign Interest Rate) “ ) is just an approximation and that we should always calculate the actual forward premium / discount. If so, should we only be using this formula when trying to find the highest hedged currency returns across different markets (because all returns would be approximated)?