In the 2016 CFAI books there is an EOC question (Reading 18, #11) which says that increased correlation between the foreign currency returns and movements in the spot rates (FX) will increase the volatility of domestic returns, but not the level of expected domestic currency returns.
I understand the volatility part. However, I assumed that if the volatility of the domestic return changed, so would the expected level. I guess they are saying that looking at a normal curve, the mean value isn’t changing but the tails are widening?
Is that accurate? Please explain to me like I am 5 years old. Thanks!
USD returns are static (not changing). But when you convert from USD to GBP - the returns in GBP can and will fluctuate if the GBP is varying a lot with respect to USD (due to the correlation between GBP and USD, GBP to USD rate rises - GBP return of that asset rises, GBP to USD rate falls GBP return of that asset falls). But during all this time the GBP return of another asset which is denominated in GBP itself may not have changed.
I think this is what they are trying to say… The domestic returns of a foreign asset can fluctuate a lot if the currency exchange rate is volatile.