US investor buys an AUD bond. expected local currency return is 8.5%. 1-year risk free yield in the US is 1.3%. 1-year risk free yield in Australia is 4.6%. spot exchange rate is 0.69 USD/AUD. 1-year forward exchange rate is 0.67 USD/AUD. if the australian currency risk is fully hedged, what is the bond’s expected return?
8.5 + (1.3-4.6) = 5.2%
Arggghhh no - I forgot the cross product.
(8.5-4.6) + 1.3 5.2% Cash flows, cash flows, cash flows. Receiving 8.5% on bond. Paying foreign interest rate of 4.6%. Receiving domestic interest rate of 1.3%.
fully hedged… .67 - .69/.69 = -2.8986% return on the currency to hedge out 8.5% on the local return. i’ll take 8.5 - 2.8986 = 5.6014% FTW? please?
bannisja Wrote: ------------------------------------------------------- > fully hedged… > > .67 - .69/.69 = -2.8986% return on the currency to > hedge out > 8.5% on the local return. > > i’ll take 8.5 - 2.8986 = 5.6014% FTW? > > please? It’s a trap! http://www.youtube.com/watch?v=dddAi8FF3F4
I hate math. OMG you just sent me star wars. that is awesome.
but really here- you hedge out, so why do you care what the RFR’s are? you just hedge it in the spot/fwd mkt, no? am i retarded? wait, don’t answer that.
Return on bond = 8.5% Forward discount = (.67-.69)/.69 = -.029 (.971)(1.085) = 1.0535 - 1 = 5.35% The forward is slightly mispriced at .67, should be .6682.
If you hedge you have to use IRP - it’s all about the arbitrage!
ok, i went with the 5.2% sucker answer. CFAI went with bannisja’s answer - 5.6%. these dudes - http://www.analystforum.com/phorums/read.php?13,974817,974817#msg-974817- seem to think CFA made a mistake and it should actually be 5.36% what do you guys think??
I like the books formula better. Easier to remember. I doubt they would ever give both answers so I will go with method A.
I think 5.36 is BP doing it with multiplication and my way was subtraction or arbitrage for dummies, if you will… wait, so I was right? Paraguay: http://www.youtube.com/watch?v=yYz3E4MckSw
Where is the problem in the book? I am glad we now need to look for mispriced forward contracts on the exam. That makes the test even more fair.
Thought it was 8.5(LC)-2.9(currency depreciation)-(.029*8.5)=5.35%? or, do you assume that being fully hedged means you leave the last piece out?
ooh i like this answer the best out of any answer yet. and yes, i often forget to cross multiply. that looks sound to me. i could be ok with us adjourning this meeting at 5.35%.
8.5% - 2.9% = 5.6% hedge return
bannisja Wrote: ------------------------------------------------------- > I think 5.36 is BP doing it with multiplication > and my way was subtraction or arbitrage for > dummies, if you will… ah i see that now. can’t understand why CFA used the “arb for dummies” way instead of the multiplication way.
answer is 5.6%
i botched this because i used IRP to determine a forward rate of 0.6682. I guess in the future the lesson is that if they give you a forward rate, don’t calculate it?