The examples given in the CFAI text for hedging decision (pg 125) seemed straight forward until i referred to the examples given in the schweser material (pg 98).
After looking into both the examples, it looks like when the currency differential (be it forward or discount) is greater than the manager’s expectations on foreign currency return, hedging should be done.
Please let me know if this is correct or not. Thanks.
It depends if they are long or short the foreign asset , plus if their expectation of movement is less or more than indicated by forward rates.
For example , if they’re long the foreign asset , you have to short the foreign currency to hedge. If rates in foreign currency are higher than domestic rates , the foreign currency is expected to depreciate .
Now , by remaining unhedged , they will lose . How much ? The difference if - id ( short term rate diff.)
If they expect the movement to be less than ( if - id ) , then they would not hedge ,as the hedge will lock them into ( if - id ), while their actual loss should be less , if unhedged.
If they expect the movement ,i.e. loss to be more than ( if - id ) , then they should enter the hedge which will limit their loss to (if-id)
If they’re short the foreign asset ( for example going to buy foreign goods and paying in foreign currency ), then the opposite is true. the larger the (if-id) term , the larger their GAIN . they can lock in a larger (if-id) if they expect the currency to move less than ( if-id) , so they should enter the hedge.
On the other hand if ( if-id) is not as large as they expect , then they should remain unhedged ( they will lock in a smaller gain than they expect ).
So they key thing to think about is:
Are they short / long , and is the currency movement expected to be in their favor or not.
If in their favor , wider movement than expected is a signal to hedge.
If against their favor , smaller movement than expected is a signal to hedge
That makes amazing sense to me. You’ve given a very clear explanation. Thanks.
A US guy has to sell Yen in 6 months
IRP says yen gonna depreciate by 3%.Manager thinks it will depreciate by 2%…
Result: its better not hedge right?
US guy gonna buy Euro in 1 year
IRP says Euro will appreciate by 5%, manager thinks appreciation to be 6%
Result: I guess it’s better hedge?!
if the US trader has to sell Yen in 6 mths , he is short forward Yen .
His hedge would be to go long forward Yen .
Let us say he enters into a hedge with long forward Yen contract with fwd discount of 3%. Any realized discount greater than 3% will leave him positive on the hedge.( he is long right? so he will get +ve payoff when realized > expected by IRP) For example if he hedges at a fwd discount of 3% and the realized discount is only 2 % he will gain on the hedge. So he should hedge, if he thinks Yen will depreciate only 2%. since -2% > -3% and he is long .
If he will buy Euro in 1 year , he is long forward Euro , so he should short forward Euro to hedge. If the premium available is 5% , but he expects realized premium to be 6% he should not hedge , He will lose on the hedge if his expectation becomes true. since 6% > 5% and he is short
Yen Scenario:
100 Y / $ Spot.
Forward IRP Discount = 3% --> Forward Rate = 97 Y/ --\> So now for 100 - he would be paying 9700 Y.
If Expected Discount = 2% -> Expected Forward = 98 Y/$ -> he would pay 9800 Y --> So he should hedge.
Euro Scenario:
Buying Euro. He will profit if :He sells a Forward Contract. and. If the Euro Depreciates.
If the Expected Euro Depreciation is MORE than the IRP -> he should hedge. If it is less - he should not.
In this case - again let us take 1 Euro / $.
If Euro appreciates by 5% -> Expected forward = 1.05 Euro / $.
he would now pay 100 / 1.05 = 95.23
If the actual = 6% -> he would now only pay = 100/ 1.06 = 94.33 - he would profit if he did not hedge.