Interest Rate Differential: The case for currency hedging

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RME
Posts: 29
Joined: Thu Jan 25, 2018 10:01 am

Interest Rate Differential: The case for currency hedging

Post by RME » Thu Jun 14, 2018 8:13 am

Hi!
As I understand, hedging a currency "costs" the differential between interest rates. Currently this differential is near 3% between EUR and USD so if you hedge the S&P 500 from USD to EUR you are "loosing" nearly 3% (without taking into account USD/EUR movements).

Image

In the same way, if i'm not wrong, the opposite thing happens if you hedge Europe Stocks (for example) to USD, you "obtain" +3% just for hedging currency.

Are this statements true?
Should US investors be hedging their European stocks to obtain a "free" 3% return?
It would be logical for an EUR investor to hold S&P500 in USD while the interest rate differential remains positive and switch to a hedged (hedged to EUR) fund if the situation reverses (Imagine a -3% differential, were EUR interest rates are 3% higher than USD).

Thanks for your answers! I'm learning so much with this community. :sharebeer

Valuethinker
Posts: 36675
Joined: Fri May 11, 2007 11:07 am

Re: Interest Rate Differential: The case for currency hedging

Post by Valuethinker » Thu Jun 14, 2018 8:59 am

RME wrote:
Thu Jun 14, 2018 8:13 am
Hi!
As I understand, hedging a currency "costs" the differential between interest rates. Currently this differential is near 3% between EUR and USD so if you hedge the S&P 500 from USD to EUR you are "loosing" nearly 3% (without taking into account USD/EUR movements).

Image

In the same way, if i'm not wrong, the opposite thing happens if you hedge Europe Stocks (for example) to USD, you "obtain" +3% just for hedging currency.

Are this statements true?
Should US investors be hedging their European stocks to obtain a "free" 3% return?
It would be logical for an EUR investor to hold S&P500 in USD while the interest rate differential remains positive and switch to a hedged (hedged to EUR) fund if the situation reverses (Imagine a -3% differential, were EUR interest rates are 3% higher than USD).

Thanks for your answers! I'm learning so much with this community. :sharebeer
I think you are misunderstanding Covered Interest Parity Hypothesis.

What it says is that if this does not hold, then there is an arbitrage opportunity opened up NOW. I.e. I could invest in EUR, say, and sell the EUR forward 12 months for the USD. That would be a profit *right now* for a USD investor.

(1+ buy currency now at spot rate) x (1+ 12m interest rate) = (1+ 12m interest rate in my home currency) x (1+ 12 m forward rate (selling my currency, buying the other currency)

So the "switch" won't work, because the profit or loss in a covered strategy is realized *right now*.

All it says is that for the risk free rate, you can't make money by (hedged) foreign exchange forward transactions.

Thus for a currency hedged fund, you are only going to make or lose money due to mismatches between the cash flows of the fund and the perfectly hedged position (plus you lose the dealing spread buying Forward or Spot on the FX market, but that should be very small).

If your yield is higher in your home currency it's because you have taken on credit risk by buying foreign fixed income instruments (greater than the risk free rate in your home currency). That plus "noise" from the mismatch of cash flows (it's never perfect).

RME
Posts: 29
Joined: Thu Jan 25, 2018 10:01 am

Re: Interest Rate Differential: The case for currency hedging

Post by RME » Thu Jun 14, 2018 7:30 pm

Valuethinker wrote:
Thu Jun 14, 2018 8:59 am
RME wrote:
Thu Jun 14, 2018 8:13 am
Hi!
As I understand, hedging a currency "costs" the differential between interest rates. Currently this differential is near 3% between EUR and USD so if you hedge the S&P 500 from USD to EUR you are "loosing" nearly 3% (without taking into account USD/EUR movements).

Image

In the same way, if i'm not wrong, the opposite thing happens if you hedge Europe Stocks (for example) to USD, you "obtain" +3% just for hedging currency.

Are this statements true?
Should US investors be hedging their European stocks to obtain a "free" 3% return?
It would be logical for an EUR investor to hold S&P500 in USD while the interest rate differential remains positive and switch to a hedged (hedged to EUR) fund if the situation reverses (Imagine a -3% differential, were EUR interest rates are 3% higher than USD).

Thanks for your answers! I'm learning so much with this community. :sharebeer
I think you are misunderstanding Covered Interest Parity Hypothesis.

What it says is that if this does not hold, then there is an arbitrage opportunity opened up NOW. I.e. I could invest in EUR, say, and sell the EUR forward 12 months for the USD. That would be a profit *right now* for a USD investor.

(1+ buy currency now at spot rate) x (1+ 12m interest rate) = (1+ 12m interest rate in my home currency) x (1+ 12 m forward rate (selling my currency, buying the other currency)

So the "switch" won't work, because the profit or loss in a covered strategy is realized *right now*.

All it says is that for the risk free rate, you can't make money by (hedged) foreign exchange forward transactions.

Thus for a currency hedged fund, you are only going to make or lose money due to mismatches between the cash flows of the fund and the perfectly hedged position (plus you lose the dealing spread buying Forward or Spot on the FX market, but that should be very small).

If your yield is higher in your home currency it's because you have taken on credit risk by buying foreign fixed income instruments (greater than the risk free rate in your home currency). That plus "noise" from the mismatch of cash flows (it's never perfect).
The yield is higher in USA not because it has more credit risk than Spain. It's because the european central bank.

I can't understand the formula, I'm not well versed in forward rate contracts (I only know that they are used to hedge currency).

My understanding is that buying US bonds hedged to EUR will return the risk free rate (Germany Bonds) and not US yields. If this is true, there is approximately a 3% "cost" for hedging.

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