Couple questions about interest rate parity and how it fits in with to hedge / or not to hedge?
1.) Does IRP mean that if it holds and fwd contracts are available, then the currency differential (return from currency appreciation or depreciation) is the only return that should be expected? That is, the Local Currency Return (as a component of total return) will equal the forward premium or discount?
2.) does “fully-hedged” mean all you’re receiving is the LCR ?
3.) if you’re future currency expectations (appreciation / depreciation) equal the markets, then does it matter if you hedge or not - you’re indifferent?
Thank you for any help!
No problem. =)
With reference to Page 125, vol 4:
I think the Local Currency Return in your qn refers to r_l, the foreign bond return in local currency terms
- if you have hedged using the fwd contracts, then HR = r_l + f (second eqn, pg 125)
Only in the case that you did not hedge, you would expect return from currency appreciation/depreciation. and the return is given as R=r_l + e (first eqn, pg 125)
- Fully hedge mean HedgedReturn, HR = r_l plus the forward discount f
so it is LocalCurrencyReturn PLUS forward discount, by IRP, f=(F-S)/S.
- Indifferent. (ignoring complications from transaction costs, value of fwd etc) example 19 illustrates the decision is purely expected currency return vs. forward premium or discount.
agree with kyh on all points
Gotcha, thank y’all.
So just to clarify. “Fully hedged” means that you are using futures contracts to hedge the currency risk and the resulting return = investment return in local currency + forward premium/discount , correct?
I guess i was under the impression that by heding you basically eliminate any related currenct return and simply receive the investment return, but that’s not right - you receive invesment return PLUS the fwd Prem/Disc (aka the currency differential) ?
And when the investment is “fully hedged”, that’s the (only) time when you choose the investment which yields the greater excess return?
Thanks for your help!!!
”Fully hedged” means that you are using futures contracts to hedge the currency risk and the resulting return = investment return in local currency + forward premium/discount , correct? Yeap =)
I’m not sure whether fwd prem/disc is known as currency differential. ‘Currency differential’ is not found in the glossary nor page 125. Could you let us know where did this term appear in the text?
_"_And when the investment is “fully hedged”, that’s the (only) time when you choose the investment which yields the greater excess return?" by this phrase, I think you are refering to the 3rd eqn,
HR = domestic RF + (localCurrencyForeignBondReturn - Foreign RF).
Moving along, this is no longer a question of deciding whether to hedge or not, we have decided to hedge. Since domestic RF is the same for all investments, now we got to choose the highest local risk premia, which is expressed as (localCurrencyForeignBondReturn - Foreign RF). [example 17]
As a side note, the question of deciding whether to hedge or not, we got to compare interest rate differential which is i_domestic - i_foreign (assuming IRP holds) vs. manager’s expectation on currency return [example 18, 19]
Hope it helps ya! =)
Thanks for the help Kyh. A follow-up to that:
Hedging doesn’t eliminate all loss or gain from the currency exposure, it merely locks in the forward premium/discount, which can still be a loss or gain? Hedging does, however, eliminate the future uncertainty bc at least you know now what to expect in the future. Is this correct?
This doesn’t apply to the use of all derivatives does it? That is, in this case, while you’re elminating any additional future price movement, you are still stuck with the premium/discount as dictated by IRP and therefore still suffer a potential loss or gain. However, isn’t the purpose of other instruments (like a protective puts for instance) used to eliminate any potential gain or loss altogether as well as lock in a certain price?
No problem BMiller12.
I agree with you that the value of the fwd contract will increase/decrease from 0 (at initiation) as time progress when the future spot rate does not equal to the forward rate. We have covered that in level II, and I’m not sure whether the difference in the two rates offsets the change in value of contract.
And yeap, I did not consider the gain/loss on the fwd contract nor transaction costs in the answer.
I’m sorry but I think I can’t comment further, I think a numerical example or someone else might be able to answer your query. =)