Could someone pls explain the foreign currency appreciation and resultant loss in short futures with a numerical example?
assume: US investor has a UK asset currently worth 100m pounds DC = $ DC RFR = 4% FC = Pounds FC RFR = 6% time period = 1y current Spot = 2/pound therefore current value of investment = $200m so the current 1y Fwd rate = $2 * (1.04) / (1.06) = 1.9623/pound ie the pound is trading at a 1.9% Fwd discount to the because it will depreciate by around 1.9% per year due to the interest rate differential --> so the US investor knows the pound is expected to fall by about 2% pa if the US investor wants to protect against the pound falling by MORE than the 1.9% interest rate differential, he can hedge by selling Fwd the pound now at the current Fwd rate. (so he locks in a loss of 1.9% now in order to avoid the possibility of an even worse loss at the end of the year) if the pound APPRECIATES (eg to $2.10/pound) instead of falling, the investor has sold short the pound so he loses: receives pounds @ $1.9623 buys pounds @ $2.10 so the loss = (Fwd0 - Spot1) / Spot0 = ($1.9623 - $2.10) / $2.00 = 6.89% loss * $200m principal = $13.77m loss on the hedge this loss on the hedge would be offset against whatever FC profit on the UK asset. hope this helps…
that’s a fairly detailed reply null. Thanks a ton!