To Hedge or Not To Hedge...

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winston1

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A portfolio manager of a Canadian fund that invests in the yen-denominated Japanese bonds is considering whether or not to hedge the portfolio’s exposure to the Japanese yen using a forward contract. Assume that the short-term interest rates are 1.6 percent in Japan and 2.7 percent in Canada.
A. Based on the in-house analysis provided by the fund’s currency
specialists, the portfolio manager expects the Japanese yen to
appreciate against the Canadian dollar by 1.5 percent. Should the
portfolio manager hedge the currency risk using a forward contract?
CFAI says its 2.7-1.6 = 1.1 (I get this part), but then it says the yen will appreciate by 1.5% so you should not hedge. I always get this part wrong. Can someone explain how to think about this please?
 
The 2.7 vs 1.6 interest rates tell us that the Yen will appreciate 1.1% – that is the increase that can be locked in using a forward contract. However, the currency specialists expect the Yen to increase 1.5%, which is obviously greater than the 1.1% that would be locked in by hedging, thus the manager is better off not hedging.
 
the @ss kicker here is that this one specialist (or PM in most questions) is somehow smarter then the whole currency market… I’m with you winston that intuitively I want to favor the market view over some wahoo…. each time i have to remind myself that for the exam I need to assume the PM believes their right and wants to trade based on his opinion (a nice segue to over confidence heuristic i guess)
 
I set these up mechanically (which helps me on test day)
In currency of pm, calc fwd diff expected by market (how much $ will appreciate, for example)
Step 2: subtract how much the manager thinks the $ will appreciate.
Step 3: If number is positive, the $ (in our example) is too expensive and we should not hedge.
 
hedging = return determined by interest rate parity (higher nominal interest rates for a country result in its currency depreciation)
not hedging = return determined by manager’s expectations. you just have to assume they’re right.
 
Rl + ( Id - If )
Lets assume my gain in Japan is 5% for example
If I hedge, using the rates given I should have 5% + (2.7%-1.6%) = 6.1%
If I don’t hedge, I believe that I will actually get 5% + ( 1.5%) = 6.5%
Therefore I should not hedge.
 
Appreciate
Manager gets currency return: 1.5%
Manager locks into forward return: 1.1%
What’s better? Manager’s return -> no hedge
Depreciate
Manager gets currency return: -1.5%
Manager locks into forward return: -1.1%
What’s better? Forward return -> hedge
Manager’s return: is simply what they expect
Forward return: interest rate differential, currency with lower nominal interest rate will appreciate
 
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