When do you leave positions hedged or unhedged?

Can someone explain this to me?

I cannot seem to understand this concept clearly.

Let’s say we are a US investor rate = 4%

Foreign rate = 3.2%

We expect the foreign currency to appreciate 0.6%

Interest Rate Differential = 0.8%

Expected apperciation = 0.6%

So hedge?

you expect it to increase +0.6% if left unhedged

market says you can make +0.8% if hedged

0.8% > 0.6% so you would hedge

if you dont hedge, you would wait until the exposure is due, you sell the Foreign currency @S[T] which gives you a 0.6% increase.

if you hedged, you would lock in the rate at which you would sell the exposure @F[T] which gives you a 0.8 %increase.

in general terms:

If you expect the currency to appreciate more than inmplied by PPP, you do not want to hedge.

If you expect a currency to depreciate less than implied by PPP, you do not want to hedge.

If you expect a currency to appreciate less than implied by PPP, then you want to hedge.

If you expect a currency to depreeciate by more than implied by PPP, then yuo want to hedge.

^ PPP or IRP?

my mistake IRP i believe is correct

quick follow up…if the question gives you both Risk Free rates (U.S =5%, Uk =2%) and exchange rates (spot U.S/U.K = 1.5 forward U.S/U.K. = 1.75) then we should use the spot and future rates to calculate the currency return instead of the risk free rates?

Yes, you hedge it with currency forwards contracts, not interest rates.

igor - do you have a sample question on it? I don’t remember anything like it (but then again, what do I remember anyways!)

You would use the currency spot and forward rates, naturally. Although you expect the arb between IRP and forward/spot rates to disappear in a split seond ( or not even exist ) , the currency spot/forward rates quoted are a reality , the IRP thing is theory

. The direct evidence of the theory is what you would bet on , not some possible other thing you did not imagine might happen between interest rates and currency rates

Isn’t that US having .8% favorable int. diffrence?

So Foiegn is expected to deppreciate? If hedged -.8% and unhedged .6%

What do you think?

US 4% and foreign 3.2%

US has to depreciate and foreign has to appreciate for IRP to hold

so foreign gains 0.8%

These are not inflation rates. If so US depreciate. But country with highg (real) int will appriciate (due to capital flow). Isn’t it?

you are thinking about the ‘4 approaches to FX determination’ whereas the question relates to interest rate parity.

Why is so there so much of confusion here? What spanishesk pointed is simple and correct. If you hold foreign currency that you wish to be converted to your domestic currency after a period of time, you have an option to hedge the currency risk or stay unhedged. If the IRP, which will determine the forward exchange rate suggest that: The foreign currency will depreciate more than what you (or manager) expect, don’t hedge. The foreign currency will appreciate less than what you expect, don’t hedge.

^ are you a big John McEnroe fan?

Thanks everyone

@mcap11: why?


go on youtube and search McEnroe Are You Serious