The curriculum (reading 21) says that correlation between foreign currency returns R(FX) and foreign currency asset returns R(FC) are greater for fixed income portfolios, and it recommends hedging.
The correlation is higher but it will be negative, if interest rates increase - bonds would fall and foreign currency appreciate against domestic currency (assuming other things are same). A negative correlation should be good for diversification and so we shouldn’t hedge the currency exposure?
The CFA curriculum tends to like interest rate parity. If your home currency is, say, GBP, and you own bonds denominated in, say, AUD, and Australian interest rates rise while British interest rates remain unchanged, then you’ll have a lower return on your AUD bonds and, according to interest rate parity, AUD will depreciate vis-à-vis GBP, so you’ll have a lower currency return as well.
I’m not suggesting that interest rate parity drives exchange rates (or, for that matter, influences them at all), but the curriculum tends to like interest rate parity.
Yes, I agree the curriculum does seem to have some inherent biases. Perhaps they shouldn’t emphasis that much on correlation being “the” factor for hedging fixed income portfolios’ currency exposure.
And surprisingly, in the very next section they describe a model in “active currency management based on economic fundamentals” that the currency exchange rate will appreciate if there’s an upward movement in either real or nominal interest rates.
To be fair, CFA curriculum mentions in the section ‘optimal minimum-variance hedges’ a study done by Campbell that the optimal hedge ratio for bond portfolios is 100% . So there may be argument to hedge fixed income portfolios.
I don’t recall ever doing such a study. I suppose that I must have, if the curriculum says so.
Ha ha. I knew it, it was you!