“Empirical evidence indicates higher, positive correlation (between asses and currency returns) in bond than in equity portfolios. This makes theoretical sense because interest rate movement tends to drive both bond prices and currency values”
However I still don’t quite get it. When rates go up, that should mean (in theory) that currency values should go up. But when rates go up, the actual value of the bond goes down since it is more attractive ti place cash in that country, so in theory, there should e a negative correlation between bonds and currency values. Why does the book state this then?
Suppose that USD interest rates increase. Then the prices on USD-denominated bonds will decline, so USD bond returns decline. Simultaneously, the USD/EUR exchange rate increases (more USD for each EUR; fewer EUR for each USD), so USD returns in EUD also decline.
Here’s how I interrupted it from the book. I could very well be wrong but this was the only way I could make sense of it.
let’s say you are long a foreign bond which means you have technically sold USD short. When interest rates increase in the foreign currency, you see a gain in the relative value of the bond priced in USD even though the bond price in the local currency has fallen relative to other assets.
Gain on currency > loss on bond market ‘local’ value.