U.S. firm is specialized in bottom-up analysis of domestic stocks and bonds, firm’s client base is equally split between U.S. based defined benefit pension plans and 401(k) defined contribution plans. Portfolios are allocated between domestic stock and domestic fixed income.
Discuss whether it is more appropriate to hedge currency exposure for international bonds or equity assets.
Solution: For bonds, because bonds are the less volatile asset class, so the volatility of the foreign currency is proportionately more significant to the foreign investor in a country’s bond market.
Can someone explain why? I would have gone for equity…
Thank you!
Domestic return = (1+ asset return in foreign currency)(1 + foreign currency return) - 1. Stated differently, there are two drivers of return when viewed from the domestic perspective: the return of the asset itself, and the return from unhedged foreign currency.
With bonds, the first component is a small proportion of the return (a risk-free US government 10-year bond, for example, yields less than 1% these days), and thus a swing of just 1% in the opposite direction on foreign currency will nullify your total return. Compare that to an equity return in 8-9%, you get the idea.
Case-specific facts notwithstanding, I am tempted to explain the choice for bonds in terms of bonds’ return correlation with foreign currency instead. In general, return on bonds are more directly correlated to the movement in foreign currency. Therefore, an adverse return in foreign currency (from the appreciation of that foreign currency with regards to your own domestic currency) will typically be accompanied by an adverse return in the bond holding itself once measured using your domestic currency. Recall that high correlation = high portfolio risk, and thus warrants more hedge.
I dont really get why if there is inflation in one country, the currency depreciates (as stayed by the PPP theory). It should be the case that because there is inflation, the central bank will increase interest rate and thus, make invesent (FI) more attractive in that country, thus increasing the demand for the currency and appreciating it (the Relative economic streng approach). So… how I am suppose to be able to answer questions like this one?. They only state that they will be inflation in NZ and no inflation (flat) in Japan.
Can someone help?
That runs afoul of the “all else equal” stipulation.
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For this question , does anyone know the source? Im just wondering why its asking about hedging currencies when its a US firm with US clients who invest in “domestic” equities and bonds?
Reading this Im confused as to what exactly needs to be hedged if there is no foreign exposure
