Stuck by the 2007 'Sample and found Fixed income part total lost Wondering whether the LOS or some fomula has been changed 1. Sample Version 2 Q16 , Cross Hedge in the FIX Part Two about the formula to calculate the cross hedged return, does it mention in the curriculum this year? 2. to be continued soon,
It will help if you provide details or write the problem out.
Risk free int rate: U.S: 4% Canada: 3% Germany: 2% Bond annual return Canada: 4% Germany: 2.5% Expected currency return Canada: 4% Germany: 1% A U.S inverstor cross hedged return in the Germany’s bond market using CAD? The answer is 7.5%, can somebody explain it?
*Punt*
I looked at 2007 exam, could not find your q- which q # is it?
If you hedge a bond, you dont earn the expected currency return, you earn the forward discount or premium. So the mechanism is: Buy German bond Sell Euro forward against CAD =Own German bond + CAD currency exposure The interest rate differntial between Germany and Canada is 1%, so interest rate parity tells us the Euro will trade at a 1% forward premium to the CAD. So when you execute the transaction, you earn the local market return on the German bond, 2.5% + the forward premium on the currency forward, 1% = 3.5%. Over this period, the CAD is expected to appreciate 4% relative to the $ and you have not hedged this risk so 3.5% + 4% = 7.5%.