Hi,
I know this is a topic that has been widely discussed over the years. Can it be broken down to a simple explanation? This is my understanding – is it that simple or could someone help point out where I go wrong in my reasoning?
t = 0
We are a US investor investing in a EUR asset and want to hedge our currency exposure.

· USD/EUR = 2 – We pay 2 dollar per EURO.

1y Forward USD/EUR = 1.90

· 1y USD interest = 10%

· 1y EUR interest = 5%

· Based on Uncovered Interest Parity it tells us the USD is expected to depreciate by 5% against the EUR over the next year (in other words, the EUR is expected to appreciate).

· This expectation is reflected in the futures price: 1y forward USD/EUR = 1.90 (5% USD depreciation). We enter into a short 1y forward to sell EUR to hedge our position in the EUR asset.

· We are here expecting a negative roll yield from hedging our position, since we are selling the EUR to a lower price in the future compared to today, but we need to do it to hedge our position. (?)

o Expecting a negative roll yield means we expect to settle our forward to a lower price compared to todays spot value(?). In other words:

If we are long the forward: F > S > Negative roll yield.

If we are short the forward S > F > Negative roll yield.
t =1
One year has gone and we now need to settle the Forward and we can now asses if we actually have had a negative or positive roll yield (?)
· We expected to have a negative roll yield. Since Forward Price < Spot Price initially.

 We settle our forward contract and buy back the EUR at 1.90 as agreed.
 a. To see if the roll yield was positive or negative we compare the price we sold EUR for with what we could have done in the spot market had we not entered a forward in the first place (?)
 i. Let’s say the exchange rate still is USD/EUR = 2. We have had a negative roll yield of 5% as expected.
 ii. Let’s say the exchange rate in the spot market now is USD/EUR = 1.71. In this case the forward has benefited us and the moves in the exchange rate has been different to what was initially priced into the future. Here we have had a positive roll yield of 10% since we made 10% on our forward?