Q20. When calculating for hedged return, why do we have to take (Long term government bond yield - 1 year interest) doesn’t make sense to me.
Q21. when calculating for undedge return, it’s bond yield + FX return (this one makes sense)
anyone could explain?
Thanks!
ctheksy
Based on my notes:
What u said about long-term is incorrect, we should use short-term
Unhedged return
= Short-term foreign risk free rate + Foreign bond risk premium + Currency appreciation return
Note: sum of the 1st 2 terms gives the foreign bond yield
Hedged return
= Short-term domestic risk free rate + Foreign bond risk premium
When u are hedging the currency exposure, you are forfeiting currency appreciation return + return on foreign risk free rate. But you are still exposed to the risk of the bond issuer, represented by the foreign bond risk premium.
Hope it is clearer now