Reading 19, Vol 4, Currency Management 6.2 Currency Options, Example 5, Question 3 UK investor has long assets in MXN.
To hedge, must sell MXN, which means buy GBP forward since quote is in MXN/GBP (long position) Meanwhile, MXN/GBP spot has declined, meaning GBP depreciated, MXN appreciated. I don’t understand why this “contributes” to the negative roll yield, meaning it is a loss for the investor, since MXN increased, which is his original asset position? I get it when the currency of the foreign asset depreciates, and you have to short a forward, it is a loss for the investor. But I don’t get why when the currency of the foreign asset appreciates, it is also a loss for the investor?
It’s a bit confusing also since the foreign asset is the price currency, not the base.
Just wanted to add, that earlier in the reading, when the investor had to sell the base currency forward, and the base currency was expected to depreciate, that was considered to be a loss to the investor (this was when they talked about the decision whether or not to hedge with a negative roll yield). This is why I’m confused…
This is a complicated example because it depends if your forward was selling at a premium (contango) or a discount (backwardation)
If it’s selling at a premium, that means if MXN/GBP depreciates, the spot rate has moved MORE down than what the premium warranted. You’re selling your forward (which was worth more at S=o) at an even lower rate than expected when you intially purchased the long forward. Bought it at ‘more’ of a premium.
When you ‘roll’ the forward, you’re purchasing the next term of the contract for MXN/GBP which now has it’s own contango relationship with the expected future spot rate.
Therefore closing the original forward at the new lower depreciated rate creates a larger loss than expected when the next forward is bought (contribution to roll-yield).
Also keep in mind roll-yield is just one component of return.
Roll-yield + spot return + collateral return = total return
@Galli Thank you! I think I get it now:
The forward was bought at a premium (long), so at expiration the price will come down to meet spot, negative roll yield, now the spot has moved lower, so the position is even more negative, more of a loss.
I also went back to the example where the investor is short the forward. In that example, the roll yield was also negative, so he had to sell the currency that traded at a forward discount, later to buy it when the forward price comes up to meet the spot. Meanwhile, the base currency depreciated, which adds to the loss because, the spot has decreased, so he will get less than originally when he buys back at spot.
I’m going to take a leap of faith and say that when there is negative roll yield, a depreciation of the base is a loss for the investor, whether or not he was long/short the forward.
^ be careful.
In the example where the roll-yield was negative the trader was short a forward that was trading at a discount. That’s the same outcome as being long a forward trading at a premium.
If he was short a forward with a premium and the spot rates moved down, he would have a negative roll-yield.
Your short the premium AND implied short in the spot rate. You buy back the spot at a lower rate than what you sold it for = profits. Reselling the premium forward would be a positive roll-yield
Good point, thank you!
In your second paragraph, if he was short the forward with a premium, and the spot rates came down, wouldn’t he still have a positive roll-yield, just less than before?