Schweser Mock - Chinese currency Q

Q18. Please confirm if I am understanding this correctly. The key is that the Chinese spread over treasuries is not expected to change, which means real long term bond returns in both countries are the same. The short term interest rates that are 3% higher in the US have nothing to do with bond returns, and only significy that the market expects the currency of the US to depreciate by 3%. Bowers believes the US currency will depreciate by only 2%, therefore he gains 1% by going long the USD.

A) US Bond ----> earn X%

B) China bond and buy the USD forward —> earn X% + (3% - 2%)

C) China bond and then sell the CNY in one year ----> earn X% - (2% - 3%)

So answer is B, as you earn same bond return but gain on the long USD forward.

I am one step behind you, so any clarification here will help. My view, which seems to be wrong, is:

If the CNY is appreciating vs USD, Why does Bowers want to buy the USD forward? Don’t you want to sell the CNY in one year since it is expected to appreciate while Bowers holds the foreign bond?

Because it’s all relative. The market expects the USD to decrease by 3%, but Bowers expects it to decrease by 2%. So on a relative basis, she can earn a 1% arbitrage return. The USD is priced too cheaply and the CNY is priced too expensively in the market. So Bowers will buy the USD forward or sell the CNY forward.

Actually I thought i had this concept down well and missed this question. The way they asked it was just very confusing to me. The way I see it, if you have a 3% yield advantage in the U.S., and you expect only 2% U.S. depreciation (versus the market’s view of 3%), then you pick up 1% by just staying long the USD.

Why would you want to short the CNY, or long the USD, if you know you are locking in 3% depreciation? I disagree with this question.

I understand the concept, I just wanted to make sure I understood the question and the vignette correctly because I also thought the wording was confusing.

The manager is based in the US and is considering a chinese bond. So remember the return formulas:

If you hedge: domestic rfr + (nominal foreign bond return - foreign rfr)

If you do not hedge: nominal foreign bond return + %change foreign currency

We are told that the nominal foreign bond returns are the same (I think). So then the only question is if you should not hedge (choice A) or hedge (choices B or C). So we look to see if there is an arbitrage. There is (3% vs. 2%). So choice A is out. Then we choose between B and C. The CNY is TOO EXPENSIVE in the market–the market believes it will go up 3% whereas you believe it will only go up 2%. So you believe the CNY will APPRECIATE LESS than the market. Therefore, hedge by going short CNY or long USD to profit on the overpriced CNY or underpriced USD.

Ok, but if you buy the USD and leave it unhedged, based on your beliefs, you will earn 3% more than the chinese bond, and only lose 2% in depreciation.

If you buy the chinese bond, you start off at a 3% yield disadvantage, and you believe the currency to only appreciate 2%, so you are still down 1%. If you then short the CNY or long the USD, you then pick up another 1%, which puts you neutral versus being up 1% unhedged on the dollar bond.

What am i missing?

The way you are looking at it is exactly how i was looking at it during the test and I picked A incorrectly.

If you just buy the USD, you don’t get the earn the 1%. You are a US investor investing in a US bond. The FCRP does nothing for you, you have no exposure to exchange risk or foreign currency.

However, if you enter the forward currency market, then you can gain from the 3% vs. 2% expectations.

The whole confusing part of this Q is that the 3% vs 2% have NO BEARING on the actual returns earned. The returns earned are the same on both bonds. The 3% vs 2% are only there to signify a FCRP/inflation differential.

Nominal yields are the same. CNY expected to appreciate 2%, but foward market lets you lock in appreciation of 3%, so sell CNY foward.

Although not in vingette, you are earning the domestic rf + the excess return over rf in China.

To put #'s around it, assume Chinese bond yields 8%, rf =2%, excess return =6%.

US bond =8%, rf=5%, excess spread =3%.

Bc fx is only going to appreciate 2%, you want to hedge lock in domestic rf + the 6% excess ret for a total return of 11%

And the returns are different:

From the example above & as a us investor:

Us bond return = 8%

China bond unhedged = 8% + 2% = 10%

China bond hedged = 8% + 3% = 11%

yup, exactly!