Currency management- CFA question

Reading 46 page 184 #5 The currency curve yield is much lower in the US than in Gr Britain. You read in nespaper that is unattractive for US investor to hedge currency risk on British assets. The same article states that British investors should hedge the currency risk on their US investments. What do you think? ***************************************** My answer was that because yield is lower in US, should appreciate (based on interest rate parity). If would appreciate, then its better for US investor to hedge, otherwise he would have currency loss. But British investor shouldn’t hedge. I read CFA answer and don’t get it

I would say that because lower US yield: -for US investor, british investments would depreciate so should hedge. (newpaper is incorrect) -for British investor, should remain unhedgd as the US currency will appreciate (newpaper is incorrect) am i right?

that’s what i thought, but have you read their answer?

By hedging you lock in the expected appreciation/depreciation. By not hedging, you subject yourself to volatile exchange rates which may not appreciate/depreciate as expected.

what is the currency curve yield ???

I assume the Curve plotting different Spot Rates/Forward Rates into the future…

Yep, I don’t get the CFA answer at all. Can someone translate?

I have read conflicting things regarding impact of interest rates on currency. Higher interests rates lead to depreciating currency through IRP. Higher interest rates lead to capital inflows for investment and currency appreciates. I like the IRP view as arbitrage is easy in currency markets. However, the second view has its charm for intuitive simplicity. May be the time horizon is different…

The question mentions the “current yield curve” not the “currency curve yield.” It’s just saying interest rates are lower in the US than in Great Britain. If IRP holds and the swap is correctly priced, then by entering into a currency swap you lock in the expected depreciation of the pound. By not hedging, you are exposed to currency risk. I could use more help understanding the second possibility that the higher-interest rate currency will appreciate.

I also thought the way atpr did. But it’s a trick question – it’s not about whether the currency is expected to depreciate or appreciate. Remember, when you enter into a forward contract, you are already paying the price, or getting the rewards of expected changes in exchange rates. You are agreeing to pay or get something different from spot – but that doesn’t mean you won or lost. So the question was basically saying – a currency hedge is appropriately priced. Do you hedge? The answer in all cases is yes, if you want to reduce the currency risk. PS… the last sentence suggests that higher rates in UK will attract non-UK investors who want to buy British pounds, thus driving up prices for pounds. This btw is contrary to IRP.

so seems like you are either long or short your currency (depending if you’re US or UK)… based on int. rate parity you expect it to appreciate or depreciate a set amount… if you believe your currency will appreciate more than that, don;t hedge… if you expect it to appreciate by a lesser amount than predicted by IRP, then lock in and hedge… does this sound correct?

Correct, but the question never gave what your own opinion was. That’s why the answer had to be hedge to remove currency risk. Because there was no reason to not hedge.

What’s the answer to this question? I would think that if the Yield Curve is currently much lower in the U.S than it is in Britain and I’m a U.S investor with assets in the UK, I would hedge my position because the U.S currency based on IRP is expected to appreciate vs. the pound. On the flip side, if I’m a British investor investing in the U.S, I would NOT hedge my position. Having said all that, if you expect the U.S currency to appreciate MORE than indicated by IRP, then hedge your UK investments. Alternatively, if you expect the U.S current to appreciate less than indicated by IRP, than you should hedge your UK investments. Always remember: (1 + Cd) - (1 + Cf)(F/So) = 0 ----> IRP For No Arbitrage To Exist PJStyles

For CFA test strategy, I think the answer is to hedge unless you know from some other source (like a proprietary model they don’t explain) that the foreign currency will appreciate by more than approximately [Rfr(domestic) - Rfr(foreign)]

So the translation of the CFA answer is that I reread their answer “Short-term currency swings can be large relative to the inetrest rate differential, so risk should be considered. To hedge currency risk could turn out to be a good decision even…” Yea… I agree with bchadwick “For CFA test strategy, I think the answer is to hedge unless you know from some other source (like a proprietary model they don’t explain) that the foreign currency will appreciate by more than approximately [Rfr(domestic) - Rfr(foreign”