this was pure beauty…
Posted by: null&nuller (IP Logged) [hide posts from this user]
Date: May 6, 2009 05:48PM
i found that if you combine Reading 41 with Reading 42(f) and (g) you get a nice set of 4 strategies that cover all bases for Fwd/Futures hedging.
When you buy a foreign asset there are 2 main risks to hedge or not hedge:
a) FC market risk (ie the risk of the foreign currency asset going up or down in value)
b) FC currency risk (ie the risk that a currency fall will bugger up any gain on the foreign asset).
so the 4 combinations are:
1) Market Risk UN-hedged + Currency Risk UN-hedged:
…….–> DC Return = (1+FC asset return)*(1+currency return) - 1 (in both readings)
2) Market Risk UN-hedged + Currency Risk HEDGED: (in reading 41 only)
…… –> DC Return = Un-hedged asset return + Return on Hedge
……where Un-hedged asset return is same as above
……and Return on Hedge = (change in Fwd prices)/Spot0
3) Market Risk HEDGED + Currency Risk UN-hedged:
……Market risk Hedged = effectively synthetic FC Cash earning the FC RFR
…..> so DC Return = (1+FC RFR)*(1+currency return) - 1
4) Market risk HEDGED + Curency Risk HEDGED:
…. you’ve locked in the FC asset return as synthetic FC cash,
…. plus you’ve locked in the interest rate differential as well
….> so DC Return = synthetic DC Cash = DC RFR
Looks complex but all you’re doing is:
If you hedge the FC Asset return you are just converting to synthetic cash so you earn the FC RFR. Then if you have left the currency risk un-hedged –> then apply the currency return to it to get the DC Return. (this is 3 above)
If you hedge BOTH the FC asset return AND the Currency risk –> you have effectively converted the FC asset into synthetic DC Cash, so you earn the DC RFR. (this is 4 above)
The bit about Hedge Ratios based on economic risk based on correlations between FC asset returns and currency moves:
–> negative correlation (eg investing in exporters) –> partial natural hedge –> need less hedging –> so Hedge ratio <1
—> positive corelation (eg investing in FC bonds) –> double whamy –> need extra hedging –> so Hedge ratio >1
To hedge or not to hedge? - basically, it only makes sense to hedge if you think the FC will depreciate by MORE than it should under IRP. eg if it is currently OVER-valued on PPP basis. This covered in a few readings but the message is basicaly the same. Good ole’ IRP - it always pops up..