Currency management

CFA Level III Portfolio Management
#1

Not clear about the blue box example in print page 417 on currency management. Would someone kind to explain it?

Now we are HK-based, have long exposures to both FC, GBP & ZAR.

spot rate HKD/GBP is 12.461

6-month forward rate is 12.655

6-month spot rate is 12.3

spot rate HKD/ZAR is 0.951

6-month forward rate is 0.9275

6-month spot rate is 0.93

So from the above,

we know HKD/GBP is trading forward premium(cost of hedge) @ 1.6%, GBP is gonna depreciate 1.3%.

Answer saying both argue for hedging.

For HKD/ZAR, it is trading at forward discount -2.5%,

ZAR is expected to depreciate 2.2%.

now we are uncertain about the hedge.

it seems to me that it does not matter whether we are trading at forward premium or discount, as long as the absolute value of cost of hedge is below the change of depreciation, we shall hedge.

is it?

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#2

basically choose the strategy that would produce the most of domestic currency (HKD)

in case of GBP, it’s better to hedge because forward rate nets us more HKD compared to the expected spot rate. Hedging actually nets a gain and sure, even though it’s possible to gain more if you unhedge, there’s also a possibility of the spot rate to move against your favor.

in case of ZAR, while unhedging seems better, there’s always a risk that your expectations might be incorrect especially when the forward rate and the expected spot rate are pretty close to each other (like in this case). so it all comes down to risk aversion, either take a certain “loss” from hedging or leave it unhedged and see if you can get a smaller loss (2.5% certain vs 2.2% uncertain).

#3

If you think that the exchange rate will be lower than IRP suggests, hedging to lock in the higher rate makes sense.

If you think that the exchange rate will be higher than IRP suggests, hedging to lock in the lower rate is stupid.

#4

Thank you, Edbert and Magician. I will revisit this in another few hours as I am mentally drained now…

#5

I would relate this to FX movement vs roll yield.

forward premium would be positive roll yield, while forward discount generates a negative roll yield.

hence in this case, GBP is yielding a higher negative roll yield cost than expected FX movement… hence we need to hedge.

ZAR is selling at forward discount, a positive roll yield, we could not hedge.

can I interpret in this way?

#6

Yes, I’ve seen numerous examples approach it this way. You interpret/calculate the unhedged return (current vs. spot, change in value) and compare it to the hedged return (current vs. forward, i.e. roll yield/carry).

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#7

Hi guys, I just went over the example from the textbook. Im wondering how to calculate the following numbers?

  1. “we know HKD/GBP is trading forward premium (cost of hedge) @ 1.6%, GBP is gonna depreciate 1.3%.”’
  2. “For HKD/ZAR, it is trading at forward discount -2.5%”
  3. “ZAR is expected to depreciate 2.2%”