International currency management

CFA Level III Portfolio Management
#1

I classify international currency management into:

  1. Investing in International Equity and 2) Investing in International Bonds

Bonds

  1. If I hedge just currency risk Rfx, and not Rfc, what is the return Rdc?

  2. If I hedge just Asset/Market risk Rfc, without Rfx, what is the return Rdc?

  3. If I hedge both market /asset risk Rfc and foreign currency risk Rfx, what is Rdc?

  4. When is the return Rdc simply the investor’s domestic risk free rate?

  5. If the foreign asset is a risk free asset, What is the return Rdc?

Equities/Index

  1. If I hedge just currency risk Rfx, and not Rfc, what is the return Rdc?

  2. If I hedge just Asset/Market risk Rfc, without Rfx, what is the return Rdc?

  3. If I hedge both market /asset risk Rfc and foreign currency risk Rfx, what is Rdc?

  4. When is the return Rdc simply the investor’s domestic risk free rate?

I am having a lot of confusion with these currency issues and would appreciate any answers you might have on them. Thanks

#2

Same applies on both, bonds and equities with difference that bond yield and risk premium are lower than equities and may be more correlated to currency returns thus are more appropriate to hedge is bond portfolio. Equity returns has more chance to offset losses on currency movements.

  1. If Rfx hedged, Rdc is Rfc ± currency forward discount/premium

  2. If Rfc hedged, Rdc is Foreign RFR

  3. If both hedged, Rfc and Rfx, Rdc is domestic RFR

  4. See Point 3

  5. If the foreign asset is RF Asset, RDC is Foreign RFR ± Rfx

#3

Forget about investing in bonds or equity. Treat it as investing in international assets. Then, your answers to the first 5 questions should be

  1. Rdc = Rfc + (Fwd-Spot) / Spot

  2. Rdc = Foreign risk-free rate.

  3. Rdc = Domestic risk-free rate.

  4. Answer is your 3rd question.

  5. (1 + Rdc) = (1 + Rfc) (1 + Rfx), Rfc = Return on foreign asset (risk free rate), Rfc = Return on foreign currency. In this case, keep in mind although the standard deviation of foreign asset (treasury) is virtually 0, however, expected risk (standard deviation) of domestic currency return will be foreign risk free rate times the foreign currency risk.

#4

Saw your post after I posted mine! All the points are exactly what you said.

#5

Great. Now he’s got helpful review. :slight_smile:

#6

Great!! Clarifies the issue for me. Thanks