In the answer to question 27, it states: “By covered interest parity, the cost of hedging a bond into a particular currency is the short-term (six months here) rate for the currency into which the bond is hedged minus the short-term rate for the currency in which the bond is denominated.”
They then take the 6 months rates, calculated the difference and then divide the answer by 2.
Ex.: (6 months euro - 6 months usd) / 2, for the usd bond hedged into euro.
Why are they dividing it by 2? As I understand it, the rates are already the 6 months rates and not the BEY nor the rate quoted on a 1 year basis. Also, the holding period is 6 months.
Can you please explain how that calculation is the “cost of hedging”?
The books do not calculate hedging cost other than opportunity/trading costs. Also, from the question, it is clear that Winston has certain expectations of exchange rates that are outside covered interest parity: “She projects that the Mexican Peso will depreciate by 2% against the Euro, the US Dollar will depreciate by 1% against the Euro, and the British Pound will remain stable versus the Euro.” Therefore, why are we using CIP?
Lastly, how does the answer then flip the hedging cost into a profit that ‘picks up’ the yield?