Refer to P235 in book 5. The free market theory states that a rise in real interest rates would lead to currency appreciation(caused by financial inflows) and lower bond prices. So a U.S bond investor in Japan would make a 10% return on from holding yen if the yen appreciates by 10%. We know that the bond price will drop. However the drop in the bond price could be GREATER OR LESS than 10%. If its less than 10%, the overall effect for the U.S investor is positive. Therefore the domestic currency exposure won’t neccessarily be negative. But, the local currency exposure will be negative. So the writing in blue in figure 4 is wrong. Check P506 of V5 in your curriculum, under the section entitled ‘currency exposure for bonds’. The term “negative domestic exposure” isnt even mentioned. The term ‘local currency exposure’ is.
What’s the difference btw domestic currency and local currency. This is PM section, right? I hate that whole PM crap…, but unfortunately L3 is going to be lots of PM questions!
the domestic currency refers to the investors currency, while the local currency refers to the currency of the investment (to use the example above: US investor invested in bonds in Japan (yen) --> domestic=USD, local = yen). As for the negative exposure: the way I understand it, its not so much the end result that terms the “negative” or “positive”, but the relationship of the movement of the values of the investment and currency respecitvely. In the example the value of the investment (bond) decreases because of the real interest rate increase, while the currency appreciates (increases in value). There is a negative relationship and hence negative foreign currency exposure. The Schweser summary for LOS 66.l (Key Concepts, p. 238) helped me understand the relationship a bit better, too. So its the correlation between the move in investment value and currency value that coins the term, not so much the end-result in terms of return to the investor… But since I’m not 100% sure, it wouldnt hurt to have somebody confirm it
Domb, you are correct as per my understanding. Domestic currency exposure = 1 + Local currency exposure. Positive or Negative Local currency exposure is determined when the value of asset denominated in its own local currency (which is a foreign currency to the investor though) goes up or down because of its Local currency appreciation or depreciation. In the above example, Local currency exposure is negtive for sure, but we cannot say anything on Domestic currency exposure to be positive or negative. It looks like a Schweser Mistake to me. Damil, domestic currency is the currency of the Investor (will be USD for a US investor). And Local currency is the currency of the foreign asset, where this US investor has invested in.