I might just be having a rough reading but some of the currency stuff is throwing me…any chance someone can help me put this in plain English? (por favor)
“But hedging costs will vary with market conditions and the higher the expected cost of the hedge (negative roll yield) the more the cost/benefit calculation moves against using a fully hedged position. Or put another way, if setting up the hedge involves selling the low-yield currency and buying the high-yield currency in the P/B pair (i.e., an implicit carry position), then the more likely the portfolio will be fully hedged or even over-hedged. The opposite is also true: Trading against the forward rate bias is likely to lead to lower hedge ratios, all else equal.”
This is about roll yield. On LONG, you achieve a positive “roll yield” when your forward curve is upward sloping ie as you move closer to maturity (moving left) the price you “roll” to the same maturity as earlier, is LOWER, providing you with “positive yield”. This is also termed “forward bias”.
Think of INR70/ fwd @ 6m to maturity is NOW INR68/@3m to maturity. On Long $, your cost of hedging is lower by INR2.
The opposite is true in a downward sloping forward curve scenario – as you move left to the curve (approaching maturity), your cost to “roll” is higher so you may sometimes choose to partially hedge ie lower “hedge ratios”.
So, the COST of hedging needs to be weighted against benefits of hedging.