Somehow this is not clicking for me. Can someone explain it in plain language? Does this depend on what your home currency is. I know in the book that says if the spread is appreciating more than what is expected, you shouldn’t hedge, but do you look at your home currency at all? Thanks!
Country A interest: 3%
Country B interest: 5%
You live in A and invest in B.
From looking at interest differential:
IRP suggests: Currency B will depretiate 2% against A or Currency A will appretiate 2% against B (it is relative). This also means that if you hedge currency risk, this is the locked-in depretiation.
scenerio 1: you forecast that currency B will depretiate 1.5%. This is unhedged expected depretiation, which is less than 2%.
This means B will depretiate less than what IRP suggests. DO NOT HEDGE. Because if you hedge, you will lose 2% instead of 1.5%
Scenerio 2: you forecast that B will depretiate 3% instead of 2% suggested by IRP.
You DO HEDGE so that you lock in a 2% loss, instead of 3% if you leave it unhedged.
Ah I got it, so when you are hedging you are using the interest rate differential right?