hedging currency exposure using Forwards - HELP PLEASE!

i thought i had this under control, but i guess not…

can someone please lay out when/why/how you would hedge currency exposure using forwards. i understand that Fwd premium/discount is based on the exhange rate differential, and interest rate parity can help you understand whether the lower yielding currency is expected to appreciate, and vice versa. But i keep coming across questions where i’m getting half correct and half incorrect based on the questioning.

i.e. CFAI 2015 mock exam (Berg Fixed Income - question 40)

update: okay i’ve learned a little more about hedging when comparing the interest rate differential vs. someone’s expectations.

i guess my confusion is trying to figure this out conceptually. how does one implement a forward hedge??

if my home currency is the euro, and i have a bond exposure in british pounds, and i expect that the pound will appreciate vs the euro (based on interest rate parity), i.e. 3.25%-2.50%, so by 0.75%…and a strategist thinks the euro will decline by only 0.35% (so the pound will only increase by 0.35%), how and why would I hedge my exposure to the pound??

Identify these

  • base currency (demoninator of the exchange rate)
  • action (selling or buying of base currency)
  • forward premium/discount of base (lock in rate)
  • interest rate differential (expected rate change) and this is your forward premium/discount when “IRP assumes to hold” is given
  • in some cases you will be given this as well - forecast rate (unhedge rate)

In your example,

The base can be either pond or euro…let’s use pound

action - selling pond and buying euro…so selling since we used pound as base

forward premium= 0.75% (pound/base at 0.75% premium)

forecast rate = 0.35% (pound/base to appreciate by only 0.35%)

The idea is to buy cheap and sell high, so ask yourself if it makes sense to lock in the rate using the forward or leaving it unhedged.

If you hedge, you lock in the rate now and sell pound for more, 0.75% more than current spot

If you unhedge, you wait and sell pound for more too but only 0.35% more than current spot)

Normally there’s the prime/discount measured by IRP (for hedging purpose), and there’s an expectation (yours, an analyst’s, an expert’s report,…etc ) . You base your decision on the delta between the expectation and the prime/discount.

thank you! so, correct me if i’m wrong. if, according to Interest Rate Parity, the USD is expect to decline/depreciate by 1% vs the EUR (assuming USD is home currency and short term rates for the USD are 3% and short term rates for EUR is 2%). If an analyst “expects” the USD to only depreciate by .75%, then i should hedge the exposure. correct? and, on the other hand, if the analyst thinks the USD will depreciate by 1.25%, then i should NOT hedge. correct?

that’s correct

If you are long the Euro and want to convert it to your home currency the USD. In the first case, you’ll get more dollars to the Euro (the dollar is at higher discount) than what would you’ll get if you dont hedge and wait. The second case is the opposite. This is the whole idea. And you’ve got it. Just be careful for when they use the opposite sense (short vs long, base vs price). Just rearrange everything to match the concept.

I am hoping that you can maybe try to help me understand this as I still find this really confusing.

You are a US investor that holds European bonds. The short term rates in Europe are 2% and 3% in the US, which means that the USD is expected to depreciate by 1% or conversely the Euro is going to appreciate by 1% by locking in the forward. If your expectation is that the USD will only depreciate by .75% why would you hedge as you are a US investor so wouldn’t you want less depcreciation on your own currency?

Is it because you are holding EURO bonds so you want to lock in a higher APPRECIATION on the EURO bond of 1% per the IRP relation as opposed to only getting .75% if you left it unhedged?

My confusion is always from the point of view of the domestic investor and what is best for him?

Any help on this would be greatly appreciated

IRP, assuming it holds, tells you the gain or loss you will lock in with hedging. In your example a US investor, if they choose to hedge and sell EUR forward, you lock in a 1% gain because someone is buying it from you in the future at a premium. So your choice is to take a somewhat riskless 1% currency gain or go unhedged and hope for a 0.75% gain. Doesn’t make sense does it? Any time you can earn a somewhat risless return that is greater than your forecast you take it all day.

Yeah you got it. It’s because you are holding the euro. Your exposure is in the foreign currency (euro) so you gain if the foreign currency appreciates