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Capital in base currency at the beginning of the investment period Capital in asset currency at the beginning of the investment period Capital in base currency at the end of the investment period Capital in asset currency at the end of the investment period
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X1, CHF
What we are interested in is to calculate the CHF return of the USD asset rA, CHF. The calculation is basically a three step procedure 1. Convert the amount to be invested from base currency to asset currency and buy the asset. 2. The asset incurs capital gains and losses in its currency over the investment period. 3. Sell the asset at the end of the investment period and convert the proceeds back into base currency.
t1
X1, USD
CHF
X0, CHF
X1, CHF
The formulas involved in the three steps are S0 S1 rA, USD Beginning spot exchange rate of the asset currency relative to base currency Ending spot exchange rate of the asset currency relative to base currency Asset return over investment period in asset currency
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t1 X1, USD
X0, CHF / S0
X1, USD S1
CHF
X0, CHF
X1, CHF
1 + rA, CHF = X1, CHF / X0, CHF = X1, USD S1 / X0, CHF = X0, USD (1 + rA, USD) S1 / X0, CHF = ( X0, CHF / S0 ) (1 + rA, USD) S1 / X0, CHF = (1 + rA, USD) S1 / S0 and finally 1 + rA, CHF = (1 + rA, USD) (1 + rS)
with rS as the spot currency return over the investment period. Note that since S1, USD/CHF is not known at the beginning of the investment period, currency risk as an additional source of investment risk enters the equation. From this exact formula, we can derive a well-known approximation 1 + rA, CHF = 1 + rA, USD + rS + rA, USD rS rA, CHF rA, USD + rS From this approximation, we can clearly see the nature of currency risk: the return of a foreign asset in based currency is nothing other than the return of a leveraged portfolio, i.e. a portfolio invested 100% in the foreign asset and 100% in the assets currency. Total risk exposure is 200%; currency risk doubles the risk exposure.
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Note that the approximation works if rA, USD rS is small, which is the case when both currency spot and asset return are small. This is the case in normal markets only, not in turbulent times. As many calculations in spreadsheets and commercial performance and risk systems are based on this approximation, we end up with the paradoxical situation that approximate analytics fail when we need them the most. The notation and illustration developed above can now be used to derive the formulas for hedged returns. We will analyze three different types of hedge implementations. In all of them, we assume that the goal is to fully hedge currency risk. The results can be easily extended to partially hedged assets, with is simply a portfolio consisting of the unhedged and fully hedged assets, with the weight of the fully hedged being the hedge ratio.
X1, USD F1
CHF
X0, CHF
X1, CHF
The only change to the unhedged situation is that F1 replaces S1. The formula for the perfectly hedged foreign asset in base currency RA, CHF is 1 + RA, CHF = ( X0, CHF / S0 ) (1 + rA, USD) F1 / X0, CHF = (1 + rA, USD) F1 / S0
The expression F1 / S0 - 1 is called the forward premium or forward discount rF, depending on whether the forward rate is above or below the current spot rate 1 + RA, CHF = (1 + rA, USD) (1 + rF)
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As before, the above expression can be approximated RA, CHF rA, USD + rF
Note that in the above calculations, we assume that we can exchange the amount X1, USD at the rate F1 agreed in t0. This is unrealistic: X1, USD is only known in t1 due to uncertainty about the assets gains and losses during the investment period. The amount to be exchanged in forward rate agreements, on the other hand, has to be specified in t0 already. The perfect hedge therefore implies perfect foresight regarding the future asset value. The forward exchange rate cannot be set at arbitrary values, as this would create arbitrage opportunities. The forward rate is determined by what is known as the covered interest rate parity, which states that the forward rate must equal the spot rate multiplied by the relative ratio of foreign and domestic riskfree rates rCHF and rUSD
rF = F1 / S0 = (1 + rCHF) / (1 + rUSD)
The exact formula for the return of the perfectly hedged foreign asset is
And the approximation formula becomes RA, CHF rA, USD + rCHF rUSD This can be read as follows: the return of the perfectly hedged foreign asset equals its return in local currency plus the difference in riskfree rates between the base currency and asset currency. Note that currency hedging completely removes the uncertainty regarding the future spot exchange rate (it can be shown that the volatility of the perfectly hedged foreign asset in base currency equals its volatility in asset currency). The perfect hedge does not result in the investor earning the local return of foreign assets; he earns the local return plus an interest rate differential. Generally speaking, the local return of foreign assets is not an investable asset; investable are only hedged, partially hedged or unhedged returns. The contribution of a foreign asset in an international portfolio cannot be altered without changing the contribution of the interest rate differential. These are
2011, Andreas Steiner Consulting GmbH. All rights reserved 5/8
the reasons why performance attribution models based on the Karnovsky/Singer approach have not become popular among practitioners: attribution effects need to be independent and tied to investable assets (we will elaborate on this point in a future research note).
t1 X1, USD
CHF
X0, CHF
X1, CHF
The exact and approximate formulas are derived as follows X1,CHF = X0,CHF (1 + rCHF) / (1 + rUSD) + ( X0,CHF / S0 ) rA,USD S1 1 + RA, CHF = (1 + rCHF) / (1 + rUSD) + (1 + rS) rA, USD
We can see that in a second order approximation, the real-world result is equal to the perfect hedge. Note that this result is only valid in the case of small interest rate differentials and small currency and local asset returns. We can expect the second order approximation to be less accurate that the perfect hedge approximation.
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t1 X1, USD
X0, CHF / S0
X1, USD S1
CHF
X0, CHF
X1, CHF
Note that we assume realistic money market hedging, i.e. we assume that we only hedge beginning market values. The exact and approximation formulas can be derived as follows
X1,CHF = (X0,CHF /S0 )(1+rA, USD)S1-( X0,CHF / S0 )(1+rUSD)S1+X0,CHF (1+rCHF) 1 + RA, CHF = (1 + rS) (1+rA, USD)- (1 + rS) (1+rUSD) +(1+rCHF)
RA, CHF rS + rA, USD - rS - rUSD + rCHF rA, USD + rCHF rUSD
The first order approximation of money market hedging is equal to the first order approximation of a perfect hedge and the second order approximation of a real-world hedge.
Numerical Examples
Let us feed the formulas derived above with some figures S0 = 1.45 X0,CHF = 100
rUSD = 1.5%
S1 = 1.435
rA, USD = 5.5% rCHF = 2%
F1 = 1.4571
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Based on these values, we can compare exact result and first and second order various approximations for the asset return NORMAL MARKETS Exact Unhedged Perfect Hedge Real-World Hedge Money Market Hedge 4.4086% 6.0197% 5.9357% 5.9586% Approximation I 4.4655% 6.0000% 5.9431% 6.0000% Approximation II 4.4655% 6.0000% 6.0000% 6.0000%
The range of the various possible calculations is 8.4bp for a parameter constellation typical for normal market conditions. In order to see what happens in turbulent market conditions, let us set S1 = 1.25 and rA, USD = 5.5%... TURBULENT MARKETS Exact Unhedged Perfect Hedge Real-World Hedge Money Market Hedge -21.9828% -9.0542% -7.6970% -7.4828% Approximation I -23.2931% -9.0000% -7.6897% -9.0000% Approximation II -23.2931% -9.0000% -9.0000% -9.0000%
Conclusions
There are several correct formulas to calculate hedged returns, reflecting various ways of implementing a currency hedge. When taking into account approximations, the number of available formulas explodes, as various degrees of approximations can be performed. Certain correct formulas are based on unrealistic assumptions and cannot be implemented in real-world portfolios. Such formulas should not be used in calculating benchmarks for performance analysis purposes. When implementing hedged return formulas, further realistic features should be considered, like variable hedge horizon and costs.
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