Schweser Question Mock Exam 1 2016 Question 3 F Hedged Currency Standard Deviation

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Mmarin3005

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Here is the Question
Sorry Can’t Copy paste but basically question asks
Stock Market return from French investor perspective is 12% SD 29%
RF rate
French 2% Australia 5%
SD of EUR is 14%
Expected change in value of EUR is +2%
Correlation of French Stocks with EUR is .3
Question states
Compute the approximate return and SD of a currency HEDGED invesment in the french stocks. I said that it would be 29% because the currency exposure is hedged….. The answer key says to use the variance equation (you all know the one) to compute the SD. Am i wrong here? I thought if the currency exposure is hedged than the only volatility comes from the asset, maybe they meant unhedged?
By the way this is from the perspective of an Australian investor
 
I’m confused as well. In my opinion, the expected change in the value of the EUR increasing 2% would result in an approximate decline in return to the investor of 2% and not an increase in return. I think Kaplan screwed up this question.
 
Well, there is a return component other than the stock market.
I read elsewhere that if the return on FX is risk-free, then the standard deviation in domestic currency is 29%*(1.02) = 29.6%
What was the answer btw?
 
Answer used the Variance equation sqrt(29%^2+14%^2+2(29%)(14%)(.30)) = 35.79%. I don’t get it, how can hedging the currency make the SD higher? Makes no sense to me. Maybe if the correlation was negative it could be higher because the diversification benefit of not hedging at that point could be significant, but in this case the correlation is positive.
 
Mmarin3005 wrote:
Answer used the Variance equation sqrt(29%^2+14%^2+2(29%)(14%)(.30)) = 35.79%. I don’t get it, how can hedging the currency make the SD higher? Makes no sense to me. Maybe if the correlation was negative it could be higher because the diversification benefit of not hedging at that point could be significant, but in this case the correlation is positive.
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You’d get a lower SD if the correlation was negative.
I’m not sure to be honest, I would have assumed that the SD should be the stock market’s, since there is no risk in currency return.
They might have screwed it up, or you missread the question. Maybe someone else can shed a light.
 
There is an errata associated with this in Schewer website: Page 11 question 3 part F the first sentence should be “Compute the approximate standard deviation of a currency unhedged investment in the French stocks and their return if the currency is hedged.”
 
Can anyone explain why for Q4 on same test statement 3 true?? Shouldn’t you have low correlation between pension investment returns and business results so firm doesn’t have to contribute to the fund when their assets underperform?? Why is the answer saying that you need high correlation?
 
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