Can someone please explain me the logic behind the answer to this question? “U.S. investor has invested in German bonds. Short-term interest rate in the U.S. is 4% and in Germany is 3.2%. The investor expects Euro to appreciate against U.S. dollar by 0.6. Assuming IRP to hold, should he or should he not hedge?” The book answer is to go ahead and hedge because the rates differential is greater than the expected return on euro of 0.6 percent. I can’t help but think that if you have investment in local currency that is likely to experience greater appreciation than you what you project, then why not continue holding it unhedged? If it is going to appreciate 0.8 as opposed to your projection of 0.6, you will get more domestic currency (U.S. dollar) when you translate local currency to domestic currency. What am I missing here?
You are missing the point , is what you’r missing. No-one is perfect at predicting the future , including the markets ( i.e. IRP ). Hence you come up with your own views on where currency will be . If you come up with a less appreciation than the market predicts , you should hedge because the market will let you LOCK in a higher appreciation than your own views of the appreciation tell you. If you come up with more appreciation that the market predicts , then remain un-hedged and thereby avoid a greater loss on the LOCK-IN created by the forward hedge
Assume $1 equals 1.5 EUR IRP says = 1*(1.04/1.032) = $1.0078 per EUR USD is expected to depreciate by (1.0078-1)/1 = .78 percent, or EUR is expected to appreciate .78 percent. You only think it’s going to appreciate .6 percent, so you should hedge.
Thanks! I can memorize the rule but I am still not sure I understand the logic. Thanks again.
If IRP holds the market is saying euro will appreciate by ~.8%. You think the market is stupid and euro will appreciate by only 0.6%. Assume your views are better than markets (that was the part that messed me up). If you hedge, you can lock in the markets views of 0.8% appreciation (NICE!) because when you are right and the euro only appreciates by 0.6% your return is better than everyone elses.
Thanks June2009! Your explanation makes sense. I think it is easy to remember this now if you only remember that “you are smarter than the market”. Thanks again.
THINK IRP=HEDGED IRP=HEDGED IRP=HEDGED IRP=HEDGED Write out the interest rates of the two countrys. One will be less than the other and the one expected to appreciate to validate IRP. This difference is the rate you can lock in with hedging; its the IRP rate. IRP= HEdged return. The Portfolio Manager or his team will also come up with an appreciation/depreciation expectation. Write this down next to the IRP/Hedged/Difference between interest rates and compare them. Whichever one is higher you go with. If the IRP/Hedged/Difference between countrys interest rates difference is higher, you go with that one (the hedged return). If your PM expectation is higher, you go with that one (if you memorize ips=hedged, this naturally leaves the PM guess to be the unhedged version). This is a helpful trick I have been using. Gluck!
I understand this stuff, but i agree the logic is still perplexing to me. By “hedging” in a 0.8% “gain” versus lets say your expectation of 0.6%, are you really “gaining” anything, or just locking in a rate that would prevent you from incurring losses when your forecast turns out to be wrong? I don’t see it so much as a “locking in a gain”, more as a “fixing your exchange rate now in order to avoid depreciating holdings when your forecast is too low” maybe im splitting hairs, i just don’t like the words “lock in a gain”… lock in what gain?
it is your ccy return bought 1 eur ag 1 usd (initial spot conversion for instance 1:1) and hedge to sell 1 eur ag 1.008 usd, ccy return 0.8pct not considering hedging the local return in this example
You’re locking a 0.8% currency gain, but still exposed to foreign market value risk.
SkipE99 Wrote: ------------------------------------------------------- > THINK > > > IRP=HEDGED > IRP=HEDGED > IRP=HEDGED > IRP=HEDGED > > Write out the interest rates of the two countrys. > One will be less than the other and the one > expected to appreciate to validate IRP. This > difference is the rate you can lock in with > hedging; its the IRP rate. IRP= HEdged return. > > The Portfolio Manager or his team will also come > up with an appreciation/depreciation expectation. > Write this down next to the IRP/Hedged/Difference > between interest rates and compare them. > Whichever one is higher you go with. If the > IRP/Hedged/Difference between countrys interest > rates difference is higher, you go with that one > (the hedged return). If your PM expectation is > higher, you go with that one (if you memorize > ips=hedged, this naturally leaves the PM guess to > be the unhedged version). > > This is a helpful trick I have been using. Gluck! thanks!