Help needed on IRP and whether to hedge or not

[Que Sera]

Can someone please explain this to me..
Berg’s committee then asks Delta to make a recommendation about whether the portfolio should be hedged back to the euro, its domestic currency. Delta responds that short interest rates are currently 2.50% in the United Kingdom and 3.25% in Germany and that Delta’s currency strategists forecast that the euro will depreciate by 0.35%.
Q: 40. Based on Delta’s expectations regarding currencies, and assuming that interest rate parity holds, should Delta most likely recommend using forward contracts to hedge the portfolio’s British pound exposure?
A. No, because the euro is expected to depreciate by more than 0.35%
B. Yes
C. No, because the euro is expected to appreciate by more than 0.35%


Answer = B
Using interest rate parity, the euro is expected to depreciate by 3.25% – 2.50% = 0.75%. Delta’s strategists believe that the euro will depreciate by only 0.35%. Based on expected returns alone, Delta should hedge the currency risk using a forward contract and lock in a 0.75% gain in British pounds.

I chose Answer A and need someone to kindly break this down for me…

 

[Que Sera]

I get the calculation involved and what we are suppose to be comparing but get lost with the notion of gain and loss to EUR/GBP in this

 

[cgy5478]

1) identify base = GBP
2) buy or sell = selling GBP
Forward rate = GBP at 0.75% forward premium
If you hedge, you sell GBP at a forward premium, a higher rate than unhedged rate (expected to appreciate by only 0.35%)
or
Buy euro at forward discount of 0.75%, a cheaper rate than the unhedge rate (expected to depreciate by only 0.35%)

 

[Audacious]

He wants to buy Euro.
Hedgin is selling at 0.75% discount
without hedging, the price will go down by only 0.35%.
with hedging, he’ll lock in a buy price for Euro that’s cheaper by 0.4 %(0.75%-0.35%).
Pocket the difference, spend it at Disneyland Paris (unfortunately no hedging for strike days)

 

[Que Sera]

AHHH i get it now, was totally looking at this from the opposite perspective
i guess i forgot to use the Fdi = Cd - Ci > 0 = Premium approach
Thanks guys much appreciated for the explanation

 

[arigolden]

The FX stuff gives me a headache. Can someone kindly explain the main concept here intuitively or from a more big picture view (if possible)?
I understand that when you borrow in a low yielding currency and invest in a high yielding currency you are selling the forward premium and buying the forward discount. But I have seen so many different interpretations of how to calculate Forward Discount, Forward Rate Bias and IRP interpretations. Can someone kindly address these points:
1) Forward Rate Bias = F - S?
2) Forward Premium/Discount = F - S / S? (what is the difference between the fwd rate bias and fwd prem/disc?)
3) Using IRP for the Berg question above
EUR is the domestic, why don’t we use 1 + Rdomestic / 1+Rforeign = (1.0325 / 1.0250) minus 1= .00732 or 0.73%. Why is GBP the base for the question above if the domestic currency is the EUR?
I have read the curriculum quite a few times now and just run a blur regarding which formula to remember and what concepts apply - any layman term guidance is highly appreciated.

 

[Audacious]

1 is a simplified form of 2.
3) compare IRP differential with FX discount or premium. Then decide based on what’s better for you (more elaboration above).
Use (1+Price)/(1+Base)-1. the Base is of the currency you want to sell or buy; regardless of its origin. In this question, you want to buy Euro. Buying Euro is equivalent to selling GBP. If you buy Euro, Euro is your base and GBP is your price. If you’re selling GBP, GBP is your base and Euro is your price.
Now, write these down, plug in numbers, change the scenarios, until you get hold of the idea

 

[arigolden]

This is helpful, thanks Audacious.