currency hedging

Can someone explain why you don’t want to hedge when you expect a currency appreciates/depreciates more than it should by IRP standards? I don’t get the reasoning behind why you wouldn’t want to hedge at all here?

It is important to follow the equations given the book so you get to see the answer to your question:

unhedged return in home currency = foreign asset return + foreign currency return

your foreign currency return is a function of interest rate differential (i.e. foreign currency appreciates to offset lower foreign interest rate)

if you hedge the curreny return with forward contracts, you will realize the embedded forward premium or suffer from the forward discount (i.e. you will lock the no-arbitrage ‘should-be’ interest rate differential)

hedged return in home currency = foreign asset return + forward premium/discount

under IRP, forwar premum/discount = no-arbitrage interest rate differential

so, if you include the offsetting the forward contract position to the unhedged foreign asset position you will get

hedged return in home currency = foreign asset return + foreign currency return - forward premium (or minus forward discount)

using interest rate diff by discussion above,

= foreign asset return + expected interest rate differential - no arb interest rate differential

now it is easy to see

do not hedge: if expected interest rate differential > no arb interest rate interest differential

so if expected currency appreciation is more than embedded forward premium, do not hedge so you realize higher appreciation

similary, if currency depreciation is less than embedded forward discount, do not hedge so you suffer less depreciation

makes sense w/ the equations now, thanks.

Looks like its all about expectations vs forward interest rate differentials…thanks