Foreign Currency Risk Premium dollars, stocks, understand, Foreign

segalm

Reading 68, p. 497, Example 5.

It's taken me a little while to understand this, and I wanted to put it into my own words. Any comments/corrections would be appreciated.

1. Expected return on Arlandian stocks (unhedged)

Swap your dollars for francs. Buy Arlandian stocks.

Arlandian stocks go up by 6%.

Now swap your francs back to dollars. Your francs are worth 3% more dollars than they were before. Gain an extra 3%.

Total gains (dollars): 9%.

2. Expected return on Arlandian stocks (hedged)

To hedge the position in Arlandian stocks, we need to sell francs forward.

The interest rate differential between the US and Arlandia is 2% (5% in US vs 3% in Arlandia).

Holding dollars at 5% should provide the same returns as exchanging for francs, holding them at 3%, and then converting back to dollars.

Therefore the forward rate should be 2% higher than the spot rate. This can be locked in, giving a total hedged return of 6% plus 2% = 8%.

3. Foreign currency risk premium

The expected appreciation of the franc is 3%. However, only 2% can be locked in today. So if you want to hedge your future supply of francs, it will cost you 1% of expected appreciation. Speculators or those who have an ongoing demand for francs can take the other side of the tride, buying them forward for 2% against the dollar. They will most likely have profitable contracts.