The paragraph reads: The expected (local currency) return on the bonds is 8.50 percent, and the 1-year risk-free yields are 1.3 percent in the U.S. and 4.6 percent in Australia. The spot exchange rate is USD0.69/AUD and the one-year forward rate is USD0.67/AUD.
Q: Given the exchange rate and interest rate data provided, if the Australian currency risk is fully hedged, the bond’s expected return will be closest to: A. 3.90%. B. 5.20%. C. 5.60%.
The differences in yield is the implied forward discount or premium. I calculated it directly from the spot and forward rates that were given in the question.
The answer is mutually exclusive. You can either have B or C. And the answer is C unless S2000 or CPK comes here and tells me otherwise.
As it turns out, the forward rate is slightly different than what we would get from intersest rate parity. For what it’s worth, it gives a return of 5.4%
So the forward rates are a total red herring here? If the prompt asked what the return would be if the hedge was initiated using the current forward rates would the answer then be C?
Foreign returns are not my area of expertise. Let me see if I get this:
Hedged Return = local RFR + foreign bond spread
Hedged w/ Forwards = local bond return x forward/discount premium
Unhedged = local bond return x % change iin Fx spots
1
Approximation = 1.3% + (8.5% - 4.6%) = 5.2%
Exact = 1.085 x (1.013/1.046) = 5.08%
2
Exact = (1.085) * ((0.67/0.69)-1) = 5.35%
If IRP held the forward discount would be equal to @ -2.9% which we should get with equations 1 &2? ((0.67/0.69)-1) = -2.9%. If the question was asking if we should hedge we would do so correct? 5.35% v 5.08%
Forward rate is the rate that you can LOCK IN so it will ALWAYS MATERIALIZE.
On on other hand, the domestic RF + country risk premium is only an APPROXIMATION and will only materialize if IRP holds , which is typically not the case.
Therefore, the Return (foreign currency term ) +/- premium/discount needs to be used if forward rate is given; only use the approximation when forward rate is not given and the interest rate differential is given instead.