Topic 9 International Diversification Flashcards
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.
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.
- 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.