Currency hedging - counter intutive explaination currency, newspaper, following, understand

cfalevel2011

Hi,

In a question in a CFAI book, the reader has to decide whether the logic in the following text correct? I do not understand the answer provided in the book.

“The current yield curve is much lower in the US than in Great Britain. You read in the newspaper that it is unattractive for a US investor to hedge currency risk on British assets. The same journal states that British investors should hedge the currency risk on their US investments.”

To me it seems counter-intuitive, because the pound is going to depreciate as per the interest rate parity theory.

However the answer of the question says that the logic is right : An American investor hedging the pound risk has to ‘pay’ the interest rate differential (British – US int rate) , while a British investor hedging the US dollar risk ‘receives’ it. It seems to be the reason why the journal suggests that Americans should not hedge their British investments and British should hedge their US investments.

Could you please help me understand the answer?

Thanks,

MG.

aidebaobao

Could you please provide the book number and page number..

justin88

I agree with you logic as well Malhar.

nannan66

Have you checked the errata? Without any additional information I can't see why you are wrong either.

I am with chaptap here, please post where we can find the problem in the books.

Analti_Calte

I agree with your logic.

There is currently nothing in the errata regarding this. If someone verifies that it is wrong, they should contact CFAI.

Colum

I don't think the CFAI agrees with what the Journal is saying. It merely tries to explain how the journal could have arrived at the conclusion.

The CFAI position for this answer is that one should hedge currency risk, even if it turns out to be expensive because the inherent volatility is not worth saving a few bucks.

liangfeng

my take is that the question is about whether you understand the logic behind the 2 statements - not whether they are correct or not.

If the US side hedges they lock in a certain loss on the Fwd rate now to avoid the possbility of a further loss later. We know most people (and companies) are risk-seeking on the downside - ie they would rather take a punt on the downside in the hope of not making a loss at all - even if they risk an even worse loss - rather than lock in a certain loss now. So the statement that US investors would tend not to hedge the pound makes sense. Of course with IRP, etc it makes no difference whether you hedge or not in the long run (assuming the currencies are fairly priced now) - but only Buffett has a long enough time horizon.

On the UK side the journal suggests UK investors "should" hedge. Most investors are risk averse on the upside - they would rather lock in a certain profit now - rather than take a punt on a bigger profit, and risk losing the certain profit. So it is understandable that the journal says UK investors would tend to hedge.

also, if the journal is implying that the yield curve difference is temporary or artificially wide relative to fundamentals (eg on PPP terms) - then their advice would be correct.

liangfeng

The problem can be found in Volume 6 of 2008 CFAI books. Page 184. Problem #5.

mcmc

This is what a currency trader in my firm tells me.

Forward exchange rates adjust immediately. So let us say, at t=0, there emerges a 1% differential between the UK rates and the US rates, the 1-year forward exchange rate will immediately drop by 1%. There is no lag.

Now if you are a US investor who invested in British assets at t=0, then selling the pound one year forward will eliminate the interest rate differential, the spread you wanted to make in the first place. However, if you believe that the pound (fwd rate) has no further downside and no way to go but up, then you should not buy the forward hedge. The opposite applies to the British investor.

It makes sense to me.

MG.

Analyze_This

Brace yourselves for a really dumb/basic i-rate parity question that I should have learned at LI or LII...

Why does the forward rate decrease by 1% to reflect the 1% higher rate in the UK? And does the spot price increase by 1%?

My rough understanding is that at t=0, when the 1% difference in rates becomes apparent, investors will want to hold Pounds to earn the 1% higher rate, so they will buy Pounds and invest for one year. At t=1, they will need to exit this position, requiring them to sell Pounds and buy back their original currency. I-rate parity suggests the spot and future prices should adjust to eliminate the arbitrage opportunity...

does any of that sound right?

Edit: can't speak english very well.



Edited 1 time(s). Last edit at Monday, April 20, 2009 at 05:08PM by ilvino.