Foreign Currency Return

Question 1

What is the foreign currency return?

Answer 1

Foregin currency return = expected appreciation - the interest rate differential

or

Overseas interest rate + expected appreciation - domestic interest rate

or

1 + away rate / 1 + expected change - domestic rate

Nominal portfolio return = (end value x end rate) / (startvalue x start rate)

Real return = ((end value x end rate) / (start value x state currency))/(1 + inflation)

Question 2

What is the spot cross exchange rate?

Answer 2

• So get what you don’t want onto the bottom
• So above we don’t want the £
• First rate the £ is on top so take reciprocal = 1/0.775 = 1.286
• Second rate the £ is already on bottom so leave it.
• Then do division, as we want USD on top this is numberator
  
  • = 1.28 / 1.83 = 0.77

Question 3

Why would an investor want to hedge a portfolio, why and what factors should they include?

Answer 3

• Merits:
  
  • This lies in the correlations between returns on domestic and foreign developed stock markets and their correlation with the return on the spot currencies.
  • Unhedged postions add extra risk in the form of the variance of the spot FX rates and often exchange rate volatility can be quite substantial, sometime more than the stock market.
  • Correlations between the spot FX rates and the domestic and foreign stok markets may offset the impact of high variance on the spot FX rates and so an unhedged portfolio may have low volatility.
  • There may even be additional diversifcation benefits from holding all the currenceis so we would want to know the correlation structure of the currencies and be able to measure net portfolio performance.
• Other factors to include:
  
  • A strong and relatively appreciating home currecny may marit an unhedged position so consider strength of home currency.
  • Many large companies already invested in will earn revenue internationally in a variety of currencies and themselves be hedged.
  • Could lead to additional benefit for the costs of hedging.
  • The time period, exected depreciation, strength of home currency, correlation structure, expense and ability to roll over.

Question 4

What is the forward rate?

Answer 4

Rate x ( 1+ away ) / (1 + home)

Question 5

What inflation rate matters most to investors?

Answer 5

The inflation rate that matters is the investors domestic inflation rate.

The away inflation rate is not the inflation rate that the client is most likely to be trying to protect their purchasing power against.

If nominal returns are deflated by the inflation rate in each count it invests in, it is not clear what the real return presented to the client indicates.

Overall, it is better to show overseas nominal returns becuase the foreign inflation rate is not relevant to the domestic investor. If the exchange rate is moving in step with differences in overseas inflation then converting local market returns to the clients domestic currency will already take account of inflation.