Foreign Currency Risk Premium

Reading 68, p. 497, Example 5. It’s taken me a little while to understand this, and I wanted to put it into my own words. Any comments/corrections would be appreciated. 1. Expected return on Arlandian stocks (unhedged) Swap your dollars for francs. Buy Arlandian stocks. Arlandian stocks go up by 6%. Now swap your francs back to dollars. Your francs are worth 3% more dollars than they were before. Gain an extra 3%. Total gains (dollars): 9%. 2. Expected return on Arlandian stocks (hedged) To hedge the position in Arlandian stocks, we need to sell francs forward. The interest rate differential between the US and Arlandia is 2% (5% in US vs 3% in Arlandia). Holding dollars at 5% should provide the same returns as exchanging for francs, holding them at 3%, and then converting back to dollars. Therefore the forward rate should be 2% higher than the spot rate. This can be locked in, giving a total hedged return of 6% plus 2% = 8%. 3. Foreign currency risk premium The expected appreciation of the franc is 3%. However, only 2% can be locked in today. So if you want to hedge your future supply of francs, it will cost you 1% of expected appreciation. Speculators or those who have an ongoing demand for francs can take the other side of the tride, buying them forward for 2% against the dollar. They will most likely have profitable contracts.

sounds right, nice job. 1) so i just get the 6% return on Arlandian stocks with the added benefit that the currency goes up 3%, so I get 9% total. OK. 2) We hedge by shorting (selling forward) Arlandian Francs, so that we gain if they go down to offset our position? So we still get the 6% return on the Arlandian stocks but don’t get the whole upside in Arlandian appreciation of 3%, instead we only add that 2% int rt differential, why? I think I get that the forward premium is just the int rt differential of 2%, so as you say, the forward rate should be 2% higher than the current spot rate. SO WHAT ARE WE LOCKING IN, that 2% return? What are we long and what are we short? 3) Right, we think the Franc will go up 3%, but we only get 2% right now, so we (Americans) pay a 1% premium to hedge. Why are we doing this? Because we hold Arlandian stocks and are worried about that currency tanking? Why would the Arlandians do this? “because of the expected return due to the currency risk premium”- WHAT DOES THIS REALLY MEAN, they just collect the premium we (Americans) pay to hedge? Sorry for sounding so dumb but I just have a lot of questions that I hope will help you too to further explain. Andrew