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.

strikethree

It is simple carry trade in FX .

From the perspective of the Domestic trader:

Sell forward FC , so you have a delivery commitment for FC for a future period.

1.You borrow FC , convert to DC at the spot , pay the FC interest rate on borrowed FC.

2. Invest DC . Earn the DC interest rate on invested amount.

3. At the expiry of the forward , convert enough DC (DC now higher because of interest accumulated ) to FC at the then spot (lower spot, but more DC to convert ) and use the FC to deliver on the forward.


Since FC has fallen over the period , the trade will work , if the market expected fall was less than your expectation i.e. the realized fall in spot is worse than market was projecting.

The no-arb case would be earning on the spot differential = loss on the interest rate differential , leaving neither party at a loss.

Roflnadal

Got it. Thanks.

Zestt

Because the only way to sell a currency fwd is to borrow it and pay the rate of that currency/country.

NakedPuts2011

when you sell FC Currency forward -- you are borrowing the FC today and selling it in the future at a price and expecting the currency value to go down. (The value is expected to go down in the future so if you sold it at the future set price, you gain).

since you are borrowing fc today - you are borrowing at the fc rate - and you need to pay that rate.

CP

bodhisattva

'When you hedge the currency risk (risk of FC decreasing), you sell the FC currency forward and therefore "pay" the FC interest rate (or borrowing at the FC rate) while earning the DC interest rate.'

I don't quite understand why the FC forward seller "borrows" at FC rate. Can you please elaborate it?

infinitybenzo

Guys:

This concept is stated on the reading 40 CFAI page 316 on the bottom under "costs" and in level 2 last year.

When you hedge the currency risk (risk of FC decreasing), you sell the FC currency forward and therefore "pay" the FC interest rate (or borrowing at the FC rate) while earning the DC interest rate. In the example provided, the FC rate>DC rate, so a hedger will end up borrowing at GBP rate, which is higher than the USD rate. This is why the journal says it might not beneficial to hedge.

Windjam

agree with mwvt9.

the CFAI answer reads confusing, but I think the purpose is to say that the journal's thoughts are wrong and "to hedge" in this case makes better sense.

however, I would suggest it use plain language in the next edition.

mik82

mwvt9,

Thanks. However, I think the argument by the journal is correct.

lcw77

Malhar,

I have just done this problem and I think I understand the explanation now.

CFAI Book 5 p 297 problem 5

“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. What do you think?”

CFAI answer

"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."

Okay. There is a reason why they put PAY and RECEIVES in quotes. It is because the CFAI doesn't necessarily agree with the statement.

The answer goes on to say:

"If the interest rate differential simply reflects the expected depreciation of the pound relative to the dollar, there is NO expected "cost" of hedging in the sense intended by the journal. Furthermore, short-term currency swings can be very large relative to the interest rate differential, so risk should also be considered. To hedge currency RISK could turn out to be a good decision, even if you have to pay an interest rate differential."

"The journal could also be suggesting that a currency with a higher interest rate tends to appreciate. Even if this statement is true on the average, exchange rates are very volatile. A currency hedge still allows the reduction of the risk of a loss."
**************************************************

I think the first sentence in the second paragraph is basically saying that if interest rate parity hold then there is no cost (no pay or rec) and the journal is wrong. They then go on to say that interest rate parity can't explain all the big swings in currency, so even if you accept the premise of the journal it may still make sense to hedge.

What do you guys think?