Total portfolio risk, optimum hedge ratio if assume that currency risk does not add a significant amount of uncertainty when the allocation to international is small

The lower the proportion of international assets, the lower the benchmark hedge ratio.

Factors to consider when selecting currency strategy (6)

- Impact on total portfolio diversification (the lower the proportion of international assets, the lower the benchmark hedge ratio)
- Other asset types in the portfolio (the lower the correlation between the portfolio return and currency movement, the lower the hedge ratio)
- Investment horizon (the longer the investment horizon, the lower the hedge ratio)
- “Weak” or “strong” currencies (if believe currency is weak, lower hedge ratio)
- Hedging costs (trading costs, admin costs, interest rate differential
- Regret aversion

Technical vs fundamental approach

Technical: supply and demand for currencies that affect the exchange rate can be non profit driven and temporary anomalies arise. Technical models built to identify predictable price patterns.

Fundamental: use economic analysis to detect undervalued or overvalued currencies.

Spot exchange rate (S)

Amount of currency that 1 unit of another currency can buy. Spot is immediately.

Forward exchange rate

The rate of exchange of two currencies set on one date for delivery at a future specified date.

Interest rate r

Rate of interest for a given period is a function of length of time period and denomination of the currency.

Inflation rate I

I is equal to the rate of consumer price increase over the period specified. Inflation differential is the difference of inflation rates between 2 countries.

Forward discount or premium

Equal to forward minus spot rate as a percentage of the spot rate.

Forward = (F-S)/S

Interest rate parity, describe, and why does it work

Interest rate parity: the forward exchange rate to a specific maturity between two freely traded currencies is determined by the zero coupon interest rates for each currency to the same maturity.

It works because:

1. Freely convertible currencies are fungible

2. It costs a negligible amount to move currency from one owner to another

Interest rate parity holds with HIGH degree of precision

Purchasing power parity

- In general does NOT hold with any precision, due to cost of transport, international barriers (quotas, quarantine)
- Law of one price implies that a the price of a basket of goods in one currency should be the same when expressed in another currency
- Big Mac index:
- PPP applies more precisely in countries experiencing hyperinflation.
- The higher domestic country inflation rate means that the domestic currency depreciates
- The real return on a specific asset should be equal for investors from all countries.

Fisher effect

The difference between interest rates in different currencies is explained by the difference in expected inflation between the currencies. Real interest rates are constant across currencies.

International Fisher Effect

Expected exchange rate differentials are reflected in interest rates. This parity relationship holds when both legs hold.

The strongest connection is via interest rate parity and the use of forward rates as an unbiased expectation of future exchange rate levels.

Uncovered interest rate parity

Combination of PPP and IFE implies that the forward foreign exchange is a market expectation of future exchange rates.

Parity relationships

- Interest rate parity nearly always holds

2. There can be significant deviations from other parity relationships.

Calculating returns on foreign investments

- Unhedged foreign investment return is a combination of the return of the foreign asset and the effect of currency variations.
- The standard deviation of the return on foreign assets is often less than the sum of the standard deviation of the return in its home currency and the SD of exchange rate gains or losses.

International performance attribution depends on (4)

- Currency selection
- Country selection
- Asset allocation within a country
- Security selection

Note, since currency hedging is possible, an investment in a particular country need not give rise to exposure to fluctuations in the value of the currency of that country.

International parity relations provide a useful base for the relationship between exchange rates, inflation and interest rates. Practical implications: (5)

- Interest rate differentials reflect expectations about currency movements. The expected return on default free bills should be equal among countries whether measured in a common currency or in real terms.
- Investing in a country with a high interest rate is not necessarily an attractive option. The high interest rate is expected to be offset by currency depreciation. Nevertheless, the interest rate is a sure thing and the depreciation is only expected
- Investors from different countries expect the same real return on a given asset, once currency is taken into account.
- Exchange risk reduces to inflation uncertainty if all these relationships hold perfectly, and, in this instance, an investor concerned with real returns would not be affected by exchange rate uncertainty.
- Currency hedging allows investors to eliminate currency risk without sacrificing expected returns, because the forward exchange rate is equal to the expected spot exchange rate.

Which is more important to an investor, the local returns or the returns in a common currency

Depends on whether the investor hedges the local currency.

If hedged, then the relevant returns are the local currency returns. If not, the relevant returns are the returns denominated in the chosen currency.

Correlation coefficient between returns of US stocks and those of other countries, vs those between US stock portfolios…

Correlation coefficient between countries is mostly 0.8

Hedge against appreciation of home currency when holding foreign assets by ……

Hedge appreciation of home currency by selling the foreign currency forward.

Primary reasons for AVOIDING investing in international assets

- Availability of information (insufficient data, interpreting and evaluating data in different forms, time lags)
- Liquidity (buy/sell, size, manner)
- Transaction costs (combination of commission plus spread plus mkt impact costs)
- Political risks
- Foreign currency risk (can be hedged though)

Primary reasons for investing in international assets

Primarily diversification due to:

- Imperfect correlation of business cycles
- Imperfect correlation of interest rates
- Imperfect correlation of inflation rates
- Exchange rate volatility