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66 hedged return=Return in foreign currency+ forward discount=8.53.16=5.34
The given answer used spot and forward price to calculate the forward discount(3.16%). However, the item set also provided foreign and domestic interest rate. The forward discount(3.3%) calculated by IRP is different with previous method.
Hedged return can also be calculated using domestic riskfree interest rate(1.3%) plus local risk premium (8.5%4.6%), it will give an answer with 5.2%.
Which method should be used here? And why?
Thank you in advance. 


Here is the question.
The expected (local currency) return on the bonds is 8.50%, and the 1year riskfree yields are 1.3% in the United States and 4.6% in Australia. The spot exchange rate is USD0.6900/AUD1 and the oneyear forward rate is USD0.6682/AUD1.
Given the exchange rate and interest rate data provided, if the Australian currency risk is fully hedged, the bond’s expected return will be closest to:
5.20%.
5.34%.
3.90%.Thank you!





The text:
“On the basis of earlier discussions with the pension fund’s managers, Chung was prepared to recommend a model portfolio with a duration of 5.0 years, measured against U.S. interest rates. More recently, Chung was told that the pension fund owns $100 million worth of Australian bonds that must be held in the $500 million portfolio for the next 12 months. These bonds have a duration of 3.2 years and Chung estimates that Australia’s country beta is 0.80. The expected (local currency) return on the bonds is 8.50%, and the 1year riskfree yields are 1.3% in the United States and 4.6% in Australia. The spot exchange rate is USD0.6900/AUD1 and the oneyear forward rate is USD0.6682/AUD1.”
@ying not that I would know how to answer this question correctly on my first attempt but after looking at the solution it’s nothing complicated at all.Basically, it’s just P/L on Foreign Bond + P/L on Currency Exchange.
Return on the bond is expected to be:
8.5%As for currency exchange P/L:
Spot exchange rate $0.69/AUD
Forward rate = $0.6682/AUDThe question asked for fully hedged, which means you will get the forward rate that you sold.
So let’s assume you did not hedge it but the forward rate will be the exact rate in 12 months time (This is exactly the same as selling a forward).
1. Buy AUD 100m @ $0.69/AUD (using $69m)
2. and 12 months later
3. Sell AUD 100m @ $0.6682/AUD (you’ll get $66.82m)66.82 / 69m – 1 = 3.159%
A loss of 3.159%, which is the same as the solution (F – S) / S = (0.6682 – 0.69) / 0.69 = – 3.16%
So to sum it up the total return would be 8.5% + (3.16) = 5.34%
Thanks for raising this question.




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