canadiananalyst

This is probably the worst we can get in the real exam... this question came to me because I met a sample/mock question similar to this. It twists the info to make it look hard, but if we stand firm at where we are, the problem will be as easy as any other question. I often got wrong if I wasn't careful about the currency quote. For example, it gives YEN/$ while YEN is the foreign currency...more practice will help.

Thank you guys, it helps me to think it from a different view. Using numbers is a very good idea.

mar350

the show NY Wrote:
-------------------------------------------------------
> actually this is trickier than i thought. i
> misread at first. the foreign currency (the
> pound) is actually appreciating. but the investor
> believes that it will appreciate less than the
> market says it will.
>
> so i think he should hedge. he should go long
> pound in the forward market.
>
> is that right?


Yep that was my thinking as well. Best way to remember this IMO is this: if the FC appreciates more or depreciates less than that predicted by IRP - Hedge. If opposite, do not hedge.

You can memorize that or sit back and think about it for a second: if I hold an asset in the UK and I think the pound is going to appreciate less than what the forward rate says, I should lock in the forward rate because its higher -> I'll get more for my money this way.

lcw77

This how I see it:

You are the French guy holding UK portfolio.

Any return will be calculated as follows:

Return in domestic/home currency [RDC] = Return in foreign currency [RFC] + Return from exchange rate changes [RXR]

RDC = RFC + RXR

Where RXR can be estimated as RDC - RFC based on the IRP

Now remember that an appreciation of the GBP (in this case) is good for the French investor, as he will be getting more EUR for each GBP he invested, once he converts (translates) his UK portfolio returns into EUR.

Going back to your example

REUR = 5%
RGBP = 1%

From the French guy point of view.

RDC = RFC + RXR ------->>>> REUR = RGBP + RXR

Market Expectation/IRP

RXR = RDC - RFC ------->>>> RXR = REUR - RGBP = 5% - 1% = 4%
(Meaning that the Euro, based on actual market rates should depreciate about 4%, which is a good thing for him)

Manager Expectations

BUT, he has different expectations, and believes that the EUR will depreciate less, let’s say only by 2%.

Now he has two options: to hedge or not to hedge

To hedge
He goes long a forward and “locks up” the exchange rate. He agreed to convert a certain amount of GBP to EUR assuming a depreciation of the EUR relative to the GBP of 4%

RDC = RFC + RXR = RFC + (RDC - RFC) = 1% + (5%- 1%) = 5%

Not to hedge
He does nothing, and if his expectations are correct, at the end of the period the depreciation of the EUR relative to the dollar is only 2%; then his return can be calculated as follows:

RDC = RFC + RXR = 1% + 2% = 3%

By, hedging his position, he has effectively locked up a 5% return, which is higher than the 3%.

UK Point of View

The opposite is true for UK investors holding EUR denominated portfolios. Since the GBP will appreciate, the RXR will be a negative number. Since the expectation is for less depreciation than what the IRP indicates, they are better off by not hedging.

RDC = RFC + RXR
RGBP = REUR + RXR
RXR = RDC - RFC ------->>>> RXR = RGBP – REUR = 1% - 4% = - 4%

Hedging: RDC = RFC + RXR = RFC + (RDC - RFC) = 5% + (1%- 5%) = 1%
Not Hedging: RDC = RFC + RXR = 5% + (-2%) = 3%