if the current yield in US is lower than great britain then according to F-S/ S = (r($) - r§)/( 1+r §) , the pound depreciates in the future, then why is it unattractive for a US investor to hedge ? shouldnt he hedge
It also says in the answers that currency with higher interest rate tends to appreciate!!!
It seems to go against everything i know. Can somebody help me resolve this conflict !!!
Hedge it or not, you also need to consider the investor own expectation. if investor expects pound to depreciate lower than market expectation, he would leave it unhedged.
With higher interest rates, the currency may appreciate in the short-term as more foreign investors come into the market to take advantage of the higher rate. Think about the CME section on forecasting exchange rates, the relative economic strength approach. (Check Page 97 in Reading 18) This is a short-term effect though. Over a longer period, the country with the lower rate (which in this case is the U.S.) should appreciate equal to the interest rate differential.
The answer to the question suggests that the journal is incorrect (or at least not completely correct) for the following reasons:
A currency hedge reduces the risk of a loss due to swings in exchange rates (on either side). This is if you don’t have an expectation regarding the appreciation / depreciation of a currency. If you do, then you’d take your expectation into consideration when determining whether to hedge.
There is no expected “cost” as the journal suggests, since the pound is expected to depreciate relative to the dollar (as you pointed out).
In general, if expectations of currency movements will be better/greater than IRP implied forward rate (domestic rates - foreign rates), then don’t hedge. Else hedge.
Eg.
if you expect DC/FC to be 2% and hedged return is 4%, then hedge if you expect DC/FC to be 2% and hedged return is 1%, then don’t hedge if you expect DC/FC to be -2% and hedged return is -4%, then don’t hedge if you expect DC/FC to be -5% and hedged return is -4%, then hedge