Hi Brave Ones,
Appreciate your comments once again, if possible at all:
“The (fully) hedged return, HR, is equal to the sum of rl plus the forward discount (premium) f, which is the price the investor pays (receives) to hedge the currency risk of the foreign bond.”
Why do they have RECEIVES linked with PREMIUM? Why does premium leads to receive (instead of paying to hedge the bond)?
Has this something to do with Foreign Currency Risk Premium (level 2) where they say that if FCRP is positive, than UNHEDGED return is greater than HEDGED? Is the investor being compensated, hence “RECEIVE”, for hedging when it was not necessary to do so?
well, hope I can get some thoughts from you guys.
all the best,
tigas
(Level III 2012 Volume 4 Fixed Income and Equity Portfolio Management, 5th Edition. Pearson Learning Solutions p. 135).
Remember you are hedging against an adverse change in the exchange rate at the time the deal matures. Spot rate is known with certainty and forward is quoted by a dealer. Forward is the agreed spot at which you will be able to convert at a later date . If this rate is higher than current spot ( i.e. the foreign is expected to depreciate) , then it is a discount because the realized conversion yields less , which is effectively a payment over current terms. If the rate is lower than current spot ( so the expectation is an appreciation of the foreign ) then the investor is going to get more back in the future and so “RECEIVES” . Either way no one really knows how much the investor finally benefits , we only know that the investor is locked in ( hedged) against big losses and will not get big gains either.
I got the explanation. Many thanks. Just wonder if discount= forward rate lower than spot and premium (domestic currency appreciated)? forward rate higher than spot (domestic currency depreciated). Didn’t you actually mean lower instead of higher and vice-versa? many thanks
You are right from the investor’s perspective. If you are a European investor investing in the US, you would like quotations of Euros per dollar . Let’s say you have an asset maturing in 12 months which is located in the US. As the European investor who fears a dollar devaluation you would like to lock in the conversion rate you are getting today , because you are worried you will not get so many Euros per dollar in the future as you can notionally get today. So you short the Dollar using the forward rate . Now if the dollar devalues as expected , you will be hedged and for a defined payment ( = forward discount ) you get peace of mind . i.e. you won’t lose more than this discount. Of course you will also not get MORE than this if the dollar does not depreciate ( or even appreciates ) as much as you and the dealer agreed it would. Now if both you and dealer think the dollar is currently devalued and will appreciate , you can still lock in the gain you imagine you will get by shorting the dollar. ( lets say you are greedy or fear that the dollar may not appreciate as much as the forward rate is But this time since the term ( f-s)/s is positive ( you are getting more Euros per dollar than now ), the dealer pays you the premium (f-s)/s i.e. you RECEIVE the premium for taking the risk of shorting the dollar when it is expected to appreciate.
Many thanks janakisri. think I got it…hopefully!