Hi, In a question in a CFAI book, the reader has to decide whether the logic in the following text correct? I do not understand the answer provided in the book. “The current yield curve is much lower in the US than in Great Britain. You read in the newspaper that it is unattractive for a US investor to hedge currency risk on British assets. The same journal states that British investors should hedge the currency risk on their US investments.” To me it seems counter-intuitive, because the pound is going to depreciate as per the interest rate parity theory. However the answer of the question says that the logic is right : An American investor hedging the pound risk has to ‘pay’ the interest rate differential (British – US int rate) , while a British investor hedging the US dollar risk ‘receives’ it. It seems to be the reason why the journal suggests that Americans should not hedge their British investments and British should hedge their US investments. Could you please help me understand the answer? Thanks, MG.
Could you please provide the book number and page number…
I agree with you logic as well Malhar.
Have you checked the errata? Without any additional information I can’t see why you are wrong either. I am with chaptap here, please post where we can find the problem in the books.
I agree with your logic. There is currently nothing in the errata regarding this. If someone verifies that it is wrong, they should contact CFAI.
I don’t think the CFAI agrees with what the Journal is saying. It merely tries to explain how the journal could have arrived at the conclusion. The CFAI position for this answer is that one should hedge currency risk, even if it turns out to be expensive because the inherent volatility is not worth saving a few bucks.
my take is that the question is about whether you understand the logic behind the 2 statements - not whether they are correct or not. If the US side hedges they lock in a certain loss on the Fwd rate now to avoid the possbility of a further loss later. We know most people (and companies) are risk-seeking on the downside - ie they would rather take a punt on the downside in the hope of not making a loss at all - even if they risk an even worse loss - rather than lock in a certain loss now. So the statement that US investors would tend not to hedge the pound makes sense. Of course with IRP, etc it makes no difference whether you hedge or not in the long run (assuming the currencies are fairly priced now) - but only Buffett has a long enough time horizon. On the UK side the journal suggests UK investors “should” hedge. Most investors are risk averse on the upside - they would rather lock in a certain profit now - rather than take a punt on a bigger profit, and risk losing the certain profit. So it is understandable that the journal says UK investors would tend to hedge. also, if the journal is implying that the yield curve difference is temporary or artificially wide relative to fundamentals (eg on PPP terms) - then their advice would be correct.
The problem can be found in Volume 6 of 2008 CFAI books. Page 184. Problem #5.
Don’t have the 08 books. My guess would be along the lines of sid and null. There is no way the actual implementation is correct though.
This is what a currency trader in my firm tells me. Forward exchange rates adjust immediately. So let us say, at t=0, there emerges a 1% differential between the UK rates and the US rates, the 1-year forward exchange rate will immediately drop by 1%. There is no lag. Now if you are a US investor who invested in British assets at t=0, then selling the pound one year forward will eliminate the interest rate differential, the spread you wanted to make in the first place. However, if you believe that the pound (fwd rate) has no further downside and no way to go but up, then you should not buy the forward hedge. The opposite applies to the British investor. It makes sense to me. MG.
Brace yourselves for a really dumb/basic i-rate parity question that I should have learned at LI or LII… Why does the forward rate decrease by 1% to reflect the 1% higher rate in the UK? And does the spot price increase by 1%? My rough understanding is that at t=0, when the 1% difference in rates becomes apparent, investors will want to hold Pounds to earn the 1% higher rate, so they will buy Pounds and invest for one year. At t=1, they will need to exit this position, requiring them to sell Pounds and buy back their original currency. I-rate parity suggests the spot and future prices should adjust to eliminate the arbitrage opportunity… does any of that sound right? Edit: can’t speak english very well.
^^ shameless bump for the Monday evening crew
<< ilvino said : At t=1, they will need to exit this position, requiring them to sell Pounds and buy back their original currency. >> The FX dealer will not let you have that risk-free profit. It will immediately adjust its forward currency rate to remove that arbitrage opportunity.
Ok that makes sense then. Thanks for the clarification Malhar!
Malhar, I have just done this problem and I think I understand the explanation now. CFAI Book 5 p 297 problem 5 “The current yield curve is much lower in the US than in Great Britain. You read in the newspaper that it is unattractive for a US investor to hedge currency risk on British assets. The same journal states that British investors should hedge the currency risk on their US investments. What do you think?” CFAI answer “An American investor hedging the pound risk has to “pay” the interest rate differential (British – US int rate) , while a British investor hedging the US dollar risk “receives” it. It seems to be the reason why the journal suggests that Americans should not hedge their British investments and British should hedge their US investments.” Okay. There is a reason why they put PAY and RECEIVES in quotes. It is because the CFAI doesn’t necessarily agree with the statement. The answer goes on to say: “If the interest rate differential simply reflects the expected depreciation of the pound relative to the dollar, there is NO expected “cost” of hedging in the sense intended by the journal. Furthermore, short-term currency swings can be very large relative to the interest rate differential, so risk should also be considered. To hedge currency RISK could turn out to be a good decision, even if you have to pay an interest rate differential.” “The journal could also be suggesting that a currency with a higher interest rate tends to appreciate. Even if this statement is true on the average, exchange rates are very volatile. A currency hedge still allows the reduction of the risk of a loss.” ************************************************** I think the first sentence in the second paragraph is basically saying that if interest rate parity hold then there is no cost (no pay or rec) and the journal is wrong. They then go on to say that interest rate parity can’t explain all the big swings in currency, so even if you accept the premise of the journal it may still make sense to hedge. What do you guys think?
mwvt9, Thanks. However, I think the argument by the journal is correct.
agree with mwvt9. the CFAI answer reads confusing, but I think the purpose is to say that the journal’s thoughts are wrong and “to hedge” in this case makes better sense. however, I would suggest it use plain language in the next edition.
Another confusing question. CAFI Vol5, Page 323, Q5.
“What do you think?” --This is actually from the question(Q5), but it’s also my question.
Guys: This concept is stated on the reading 40 CFAI page 316 on the bottom under “costs” and in level 2 last year. When you hedge the currency risk (risk of FC decreasing), you sell the FC currency forward and therefore “pay” the FC interest rate (or borrowing at the FC rate) while earning the DC interest rate. In the example provided, the FC rate>DC rate, so a hedger will end up borrowing at GBP rate, which is higher than the USD rate. This is why the journal says it might not beneficial to hedge.