Can anyone please explain the question? I can’t quite understand. Many Thanks!
strong textDetermine whether the Tauravia bonds would have a higher expected return over the coming year if the
currency exposure is fully hedged or unhedged. Justify your response. Show your calculations.
Note: Assume MacDougal’s spot exchange rate forecast is correct and there are no changes in the yield
curves.
The Tauravia bonds have a higher expected return if unhedged. The unhedged return is approximately equal to the foreign bond return in local currency terms, rl, plus the currency return, e, which is the expected percentage change in the spot exchange rate stated in terms of the home currency per unit of foreign currency. The unhedged return ≈ rl + e.
The expected change in the spot rate of the TRF is:
e = (St+1 – St) / St
= (1.97 – 2.00) / 2.00
= –0.015 or –1.5%
The unhedged return ≈ 7.50% + ( –1.50%) = 6.00%.
If MacDougal hedges the currency risk using a forward contract, the hedged return will be
approximately equal to the local risk premium, plus the domestic interest rate. Alternatively,
the hedged return is approximately equal to the local return plus the forward premium (the difference between the domestic and foreign risk-free interest rates). This is true because, by entering into the forward contract, MacDougal would be effectively paying the foreign interest rate and earning the domestic interest rate. Therefore, the fully hedged return is:
Hedged Return ≈ 𝑟𝑟𝑙𝑙 + (𝑖𝑖𝑑𝑑− if) = 𝑖𝑖𝑑𝑑+(𝑟𝑟𝑙𝑙−𝑖𝑖𝑓𝑓).
The fully hedged return ≈ 1.80% + (7.50% – 4.00%) = 1.80% + 3.50% = 5.30%.
Alternatively, the expected currency change of –1.50% is greater than the TRF forward premium of –2.20% (=1.80% – 4.00%) under IRP. Therefore, the expected currency loss is less if the bond is unhedged than if it is hedged, and the Tauravia bonds have a higher expected return if unhedged.
Alternative response:
The same conclusion can be reached by comparing the IRP forward rate with the future forecast spot exchange rate.
Future forecast exchange rate = 1.97 SCF/TRF
The IRP forward rate can be calculated as: 2.00 spot rate × (1.018 /1.04) = 1.9577 SCF/TRF
Since the IRP forward rate is lower than the future forecast spot exchange rate, the currency risk
should be left unhedged.