I have been looking at the Hedging decision reading and it looks a bit counterintuitive to me.
Page 281 - for those of you who use Kaplan, states that if the foreign rate is higher than the investor’s domestic rate, the foreign currency will trade at a forward DISCOUNT. Now I understand that this comes from the IRP formula. However wouldn’t you expect an appreciation of a country’s currency when that country’s rates are high enough to attract foreign capital? If this is the case, shouldn’t we expect the foreign currency to trade at a premium and not a discount?
You have to understand what the statement “the foreign currency trades at a forward discount” means.
It has nothing to do with predicting the future exchange rate of the currencies. Forward rates don’t do that.
It has everything to do with preventing arbitrage. That’s all that forward rates do.
It simply means that the forward price for the foreign currency is lower than the spot price.
It’s funny: most people wouldn’t believe for an instant that the forward price on, say, Google stock, is any sort of prediction of the price at which Google stock will be trading in the future, but they’re absolutely convinced that the forward price on, say, JPY is some sort of prediction of the price at which JPY will be trading in the future. Weird.
Also funny thing is when I talk to traders they all use S&P 500 futures as a market indicator before the opening bell. They aren’t trading around it i’m sure but it’s like they get their morning mind set ready around that. Even though it’s such a horrible indicator i wonder why they even bother with it.
Ok S2000, coming back to this. I see your point here however don’t we base our decision to hedge or not to hedge whether or not the expected appreciation of one currency over the other exceeds the IR differential? Doesn’t this imply that IRs predict FX movement?
That’s certainly one factor. But not the only factor. Risk tolerance enters into it.
The 6-month forward USD/GBP rate is 1.2495. You’ll be receiving GBP1,000,000 in 6 months and you think that the spot rate at that time will be USD/GBP 1.2496. Will you hedge? What if you think it’ll be 1.2502? Or 1.3417? Or 1.4146? They’re all above the rate “predicted” by the IR differential.
Not in the least.
The spot price on XYZ stock is $25/share and the 6-month forward price is $25.30. You believe that in 6 months the price will be $15/share, so you’re more than happy to take the short position in a 6-month forward contract. Bob believes that in 6 months the price will be $35/share, so he’s happy to take the long position in a 6-month forward contract. The market thinks that the price will be $25/share, or maybe $27.50/share, or perhaps $19.07/share. None of that matters; the 6-month forward price will be $25.30: today’s spot price increased by the risk-free rate. It isn’t remotely a predictor of the future price.
Nor is the forward exchange rate a predictor of future exchange rates. At all.
