Can someone please explain me the logic behind the answer to this question?
"U.S. investor has invested in German bonds. Short-term interest rate in the U.S. is 4% and in Germany is 3.2%. The investor expects Euro to appreciate against U.S. dollar by 0.6. Assuming IRP to hold, should he or should he not hedge?"
The book answer is to go ahead and hedge because the rates differential is greater than the expected return on euro of 0.6 percent.
I can't help but think that if you have investment in local currency that is likely to experience greater appreciation than you what you project, then why not continue holding it unhedged? If it is going to appreciate 0.8 as opposed to your projection of 0.6, you will get more domestic currency (U.S. dollar) when you translate local currency to domestic currency. What am I missing here?作者: Colum 时间: 2011-7-11 19:16
Assume $1 equals 1.5 EUR
IRP says = 1*(1.04/1.032) = $1.0078 per EUR
USD is expected to depreciate by (1.0078-1)/1 = .78 percent, or EUR is expected to appreciate .78 percent.
You only think it's going to appreciate .6 percent, so you should hedge.
NO EXCUSES作者: oneboy 时间: 2011-7-11 19:16
THINK
IRP=HEDGED
IRP=HEDGED
IRP=HEDGED
IRP=HEDGED
Write out the interest rates of the two countrys. One will be less than the other and the one expected to appreciate to validate IRP. This difference is the rate you can lock in with hedging; its the IRP rate. IRP= HEdged return.
The Portfolio Manager or his team will also come up with an appreciation/depreciation expectation. Write this down next to the IRP/Hedged/Difference between interest rates and compare them. Whichever one is higher you go with. If the IRP/Hedged/Difference between countrys interest rates difference is higher, you go with that one (the hedged return). If your PM expectation is higher, you go with that one (if you memorize ips=hedged, this naturally leaves the PM guess to be the unhedged version).
This is a helpful trick I have been using. Gluck!作者: pennyless 时间: 2011-7-11 19:16
You're locking a 0.8% currency gain, but still exposed to foreign market value risk.
