This is not a Q in any test, I just want to get some clarity on hedging currency risk. If you have time please put a one line explanation for your answer. If an US investor invests in UK equity index and hedges foreign currency risk, what is his domestic (US) return. a) return on UK equity index b) return on UK equity index + US risk free rate c) return on UK equity index + UK risk free rate.
b i think. If you hedge currency risk, you hedge away the interest rate differential in interest rate parity. Therefore, the domestic risk free is left because you arnet taking away any of the foreign risk (because you hedged against that currency. Not sure if I am explaining it well enough, but pretty sure b is the answer.
I believe it is A. The investor has hedged currency risk, so his return is the return on the UK index. In general the investor has two risk- UK market risk and foreign currency risk- if both are hedged the investors return is his own country’s risk free rate.
the curriculum mentions this and this is not an easy hedge. At the end of the day the only thing you will end up with is the hedged return on the principal (which will earn the forward premium or discount) and then depending on whether the position goes up or down in value, you will either be over hedged or under hedged. Let’s assume a 1 year transaction - US Rates 5% UK Rates 6% Dollar/Pound Spot Rate 1.40 Dollar/Pound 1 Year Forward 1.3860 (approx -1% differential) Principal Investment $1,000,000 or 714,2857 pounds Principal Investment after 1 year hedge $990,000 Return -1% = rate differential. Now the investment goes up 10% = you have 71,487 pounds un-hedged to convert. Who knows where spot will be in a year? If the investment goes down 10%, then your principal has gone down by 71,487 pounds and you are over hedged. Depending on what the currency did, you either made more or lost more. Impossible to tell, not an effective hedge.