Someone please confirm: If hedging market risk only, return should be foreign risk-free rate. If hedging both market risk and currency risk, return should be the domestic risk-free rate.
We have a winner !!! pimp, you got it right
this was pure beauty… Posted by: null&nuller (IP Logged) [hide posts from this user] Date: May 6, 2009 05:48PM i found that if you combine Reading 41 with Reading 42(f) and (g) you get a nice set of 4 strategies that cover all bases for Fwd/Futures hedging. When you buy a foreign asset there are 2 main risks to hedge or not hedge: a) FC market risk (ie the risk of the foreign currency asset going up or down in value) b) FC currency risk (ie the risk that a currency fall will bugger up any gain on the foreign asset). so the 4 combinations are: 1) Market Risk UN-hedged + Currency Risk UN-hedged: …–> DC Return = (1+FC asset return)*(1+currency return) - 1 (in both readings) 2) Market Risk UN-hedged + Currency Risk HEDGED: (in reading 41 only) … --> DC Return = Un-hedged asset return + Return on Hedge …where Un-hedged asset return is same as above …and Return on Hedge = (change in Fwd prices)/Spot0 3) Market Risk HEDGED + Currency Risk UN-hedged: …Market risk Hedged = effectively synthetic FC Cash earning the FC RFR …> so DC Return = (1+FC RFR)*(1+currency return) - 1 4) Market risk HEDGED + Curency Risk HEDGED: … you’ve locked in the FC asset return as synthetic FC cash, … plus you’ve locked in the interest rate differential as well …> so DC Return = synthetic DC Cash = DC RFR Looks complex but all you’re doing is: If you hedge the FC Asset return you are just converting to synthetic cash so you earn the FC RFR. Then if you have left the currency risk un-hedged --> then apply the currency return to it to get the DC Return. (this is 3 above) If you hedge BOTH the FC asset return AND the Currency risk --> you have effectively converted the FC asset into synthetic DC Cash, so you earn the DC RFR. (this is 4 above) The bit about Hedge Ratios based on economic risk based on correlations between FC asset returns and currency moves: --> negative correlation (eg investing in exporters) --> partial natural hedge --> need less hedging --> so Hedge ratio <1 —> positive corelation (eg investing in FC bonds) --> double whamy --> need extra hedging --> so Hedge ratio >1 To hedge or not to hedge? - basically, it only makes sense to hedge if you think the FC will depreciate by MORE than it should under IRP. eg if it is currently OVER-valued on PPP basis. This covered in a few readings but the message is basicaly the same. Good ole’ IRP - it always pops up…
Thanks for pulling this up mumu. null&nuller good job on breaking down the logic. Thank you.
BUT, remember that you can’t perfectly hedge currency risk unless you were to know exactly what the final value (gain/loss) on the assets will be over the relevant period. The suggestion is to hedge the principal / initial market value to minimize the difference.
mumukada, It seems that you are excellent in foreign currency risk management. I will like to have your advice on CFAI’s 09 Free Sample Exam Q18. Why the bond’s return is not calculated in the way same as the that in foreign equity [just as your way of 1)] ? Except that the coupon payment is certain and can be hedged away as well as the principal.
sorry amc. 1. i’m not excellent in foregin currency risk management…not excellent in anything for that matter!..that post was something null and nuller had put up a while back to help me remember it easily…so you might wanna call out to him… 2. i haven’t done the sample exam yet…so can’t really answer your question on that…
OK, I will like to have null&nuller’s advice. Anyway, TKVM !
AMC, the bond return for Q18 is calculated as in step 2 listed by null&nuller because for that particular question the currency was hedged.
heer, Actually, it is not calculated in the way exactly same as in step 2 listed by null&nuller. What I mean is that the calculation of currency discount/premium in the solution of Q18 is quite different from that in step 2. In step 2, there is gain or loss from futures or forward contract. But currency discount/premium is used directly in the solution of Q18 which is quite different from. Would you please kindly advise why ? Anyone can advise ?
I do see your point. I am looking at the solution now and you are right they take the forward discount or premium. Hmm I still read this as the hedged return on currency.