EnjoyIt wrote: ↑Fri Aug 07, 2020 4:19 pm
To follow up, what if the exchange rate in the future is higher than 1.189. Doesn't that mean this hedging created a lower return if there was no hedging to begin with?

That's right. By hedging back to the USD, you know exactly what exchange rate you'll get and now currency fluctuations don't affect you at all. If the exchange rate is more or less favorable in the future, you still get that 1.189 exchange and hence, the additional 0.7% return. If you don't hedge, you could get more, less or the same.

By the way, this might make you believe hedging is ideal or better than not hedging. This isn't true. There are no free lunches here. Hedging eliminates one risk (foreign currency) and introduces another (USD inflation risk).

What we can say is the following:

1) If you see a foreign bond fund that hedges, the SEC yield is not the full story. But you can get very near to the full story by checking out forward rates. Since it hedges, you should expect to receive very nearly what those contracts show.

2) If the fond does not hedge, the SEC still isn't the full story. But now, you don't really know what you might receive in the future. It should be close to a hedged position on average, so you can approximate it by looking at the forward rates as well.

EnjoyIt wrote: ↑Fri Aug 07, 2020 4:19 pm
Maybe a more important question, why is an exchange of currency somehow more favorable 3 months from now than it is today? Isn't money more valuable now than in the future? Maybe this is what stems my confusion.

Ok here's the intuition:

1) Currency is almost always more valuable today than in the future. How much more valuable? It depends on the interest rate of the currency. If USD interest rates are 1%, the future value of 1 USD today is 1.01 USD. Put another way, 1.01 USD in the future is really worth more like 1 USD today. You discount based on the interest rate.

2) The lower the interest rate, the smaller that difference. If interest rates are negative, future currency actually is worth more.

So the

**difference** in the value of two currencies in the future (their future exchange rate) stems from the difference of their discount rates (i.e. interest rates).

USD interest rates are at 0% so the future value of a dollar is about the same as a current dollar. But Euro interest rates are negative, so the value of a future Euro is greater than a current Euro. So if USD in a year from today are as valuable as today, but Euros a year from today are more valuable than today, then the exchange rate of the Euro offered in the future market would have to be more attractive than the exchange rate today.

This relationship is maintained by arbitrage as someone else mentioned.

"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson