domestic currency Interest rates + Local market returns - foreign currency interest rates. Will this represent hedge returns or un-hedge returns?
Hedged.
Based on this can you suggest me the correct answer for me:
The expected (local currency) return on the bonds is 8.50%, and the 1-year risk-free yields are 1.3% in the United States and 4.6% in Australia. The spot exchange rate is USD0.6900/AUD1 and the one-year forward rate is USD0.6682/AUD1. USD is domestic and AUD is foreign local currency 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) 5.34 B) 3.90 C) 5.20
The Aussie interest rate is 4.6% and the US rate is 1.3% so the Aussie dollar is expected to devalue against the USD by 4.6 - 1.3 = 3.3%.
You make 8.5% on the bond and lose 3.3% on the exchange rate for a total domestic return of 8.5 - 3.3 = 5.2%
I havnt done the maths but I assume the forward rate above represents properly the 3.3% devaluation. If you are fully hedged then you are locking in that negative return.
(0.6682/.69) - 1 + 0.085 = 5.34%
Correct answer is 5.34 what has been given but the problem here is why there is a difference coz if you see 0.6682 is also derived from the Interest rates given (0.69 x 1.013/1.046) = 0.6682. So either ways it should have come the same. i.e. by using (0.6682/.69) - 1 + 0.085 = 5.34% OR by using R domestic + Local market return - r foreign in this case which will be 1.6 +8.5-4.6 = 5.2
No ideas why this is happening am i missing something?
Yeah - just pulled my calculator out and the forward rate doesn’t represent the 3.3% difference in rates…Mr Smart’s answer is correct as you are locking in the loss on the forward - I was watching the football and made some lazy assumptions…
I’m also wondering Nishit’s question. On page 134 of book 4, the equation is given as:
Hedged return = rl + (id - if)
rl = local return id, if = interest rate domestic, foreign, respectively
Why do I use the forward rate to calculate the return? Is it more accurate, similar to arithmethic vs geometric?
Because you hedge using a forward contract.
Normally, the CIRP should follow the UCIRP, to eliminate arbitrage.
^ So this question says the AUD is hedged (with a forward contract), which means you use the forward rate. If the question indicates that the currency is not hedged, the correct answer would be 5.20? Which is 8.5 + (4.6 - 1.3)?
If it’s unhedged then I think usually they give an “expected appreciation/depreciation” in the currency which you would use to calculate the “expected unhedged returns”.
Watch out for phrases like “interest rate parity holds” if no explicit forward rate is given and you are asked for hedged returns, or “the expected change in currency value is…x” if you are asked for expected unhedged returns