Research & Publications
Back-to-Basics

The following article is reprinted from the June, 2000 issue of On the Edge,
the Interactive Data Fixed Income Analytics bimonthly newsletter.

Back-to-Basics: Non-US$ Investments and Hedging Exchange Rate Risk

Teri Geske
Senior Vice President, Product Development


The Multi-Currency module in BondEdge allows investment managers to incorporate non-US$ securities into their portfolios and offers a variety of reports to analyze a portfolio’s exposure to different currencies and countries, including global benchmark comparisons. The multi-currency functionality also includes the ability to incorporate currency forward rate agreements (FRAs) in a portfolio, as these commonly used hedging instruments are critical to understanding the portfolio’s exposure to currency or exchange rate risk. As a growing number of our clients are considering the benefits of adding non-US$ assets to their portfolios, this month’s Back-to-Basics column defines currency risk and illustrates how FRAs are used to reduce or eliminate this risk over a specified period of time.

Investing in debt securities issued in other countries and currencies can be a way to diversify risk, as bond market returns (price change plus interest income) are not perfectly correlated around the world. In a simple example, imagine a portfolio that contains two (option-free) government bonds, both with a yield of 6% and a duration of 5.0. If both are U.S. Treasury securities and U.S. interest rates rise by 50bps, the price of both bonds will drop by approximately 2.5% (ignoring convexity). However, if one of the bonds in the portfolio is a non-US$ security, the foreign bond’s price is not affected by a change in U.S. interest rates. Since changes in global term structures are not perfectly positively correlated, the portfolio with 50% of the assets in a foreign currency enjoys some diversification of interest rate risk over the single-currency portfolio.

While this diversification is appealing, it is important to consider exchange rate risk when evaluating global investment opportunities, as currency risk can offset the benefits of interest rate risk diversification. We can define exchange rate risk as the impact of a change in the exchange rate between an investor’s home currency and a foreign currency in which an investment is denominated. Imagine a U.S.-based investor wishes to purchase a French government bond that is priced at par, with a face value of €1,000. Assume the US$/euro exchange rate today is $0.985/€1, so to purchase the French bond the investor exchanges US$985 (1000 x 0.985) for €1,000. The next day, imagine that the exchange rate between the euro and the dollar jumps to $1.01/€ while interest rates in France, and thus the price of the French government bond, remain unchanged. The value of the €1,000 investment in U.S. dollar terms has increased from $985 to $1001, a gain of $16 per bond, due to the change in the exchange rate. Of course, if the foreign currency had depreciated against the dollar, the U.S.-based investor would suffer a loss in US$ terms.

Two concepts are often confused when discussing the relationship between currency risk and interest rates, and for those of us who have not thought about these issues in some time we thought it might be useful to review them here. One concept is known as purchasing power parity, a theory that says spot exchange rates will adjust to reflect inflation differentials between countries. If inflation in Country A increases, making a particular commodity more expensive than in Country B, buyers in Country A will exchange their currency for Country B’s in order to buy the commodity more cheaply from that country. Over some period of time, this would cause Currency A to depreciate relative to Currency B, offsetting the higher interest rates in Country A. The empirical evidence suggests that purchasing power parity does a poor job of explaining short term exchange rate movements1. A separate concept, interest rate parity, states that the forward discount (or premium) implied by the forward exchange rate between two currencies must equal the interest rate differential between the two countries. Interest rate parity must hold, or a risk-free arbitrage would force these relationships back into balance.

Interest rate parity allows us to compute the cost of hedging exposure to exchange rate moves using currency FRAs. Consider the following example: An investor wishes to choose between a U.S. Treasury note with one year to maturity yielding 6.00%, and a one year German government note yielding 5.00%. The investor, who lives in Germany, decides to invest in the U.S. Treasury which offers a yield advantage of 100bps over the German government note with no difference in credit risk. The investor sells €1,015.22 for US$1,000 at the spot rate of US$/EUR = 0.985 and purchases the Treasury for $1,000 (for simplicity, we assume the Treasury is trading at par). Since there is a risk that the $/€ exchange rate will change between today and the maturity date (at which time the German investor plans to convert the US$ proceeds back into euros), the investor wishes to lock in the rate at which the proceeds from the Treasury investment will be exchanged for euros, one year from today, i.e. one year forward, using a FRA. What forward exchange rate will be specified in the forward contract?

We can determine what the FRA rate must be with the following logic: At the maturity date one year from today, the initial US$1,000 investment will be worth US$1,060 ($1,000 x 1.06, ignoring semi-annual compounding). If the initial €1,015.22 equivalent had been invested in the German bond, that investment would be worth €1,066 (€1,015.22 x 1.05) one year from today. Since these two investments alternatives are both risk-free (no default risk, virtually no event risk, etc.), today’s one year forward exchange rate must be the rate which makes these two payoffs equal, i.e. US$1,060/€1,066 = 0.994. The percentage change in the spot exchange rate versus the forward rate is referred to as the “forward premium” (or “forward discount”); in this example, it is 0.9944/0.985 = 0.954%, roughly equal to the current 1.00% interest rate differential between the two countries. Therefore, if an investor chooses to eliminate the exchange rate risk, the cost of the hedge (the forward premium) offsets the interest rate differential.

In this example, by fully hedging the exchange rate risk at the time of the purchase, the German investor can eliminate the risk of the U.S. dollar depreciating relative to the euro. The investor may choose to take a position that the exchange rate at the one year maturity date will be more favorable than the forward rate implied by the one year interest rate differential today. In this case, he or she might hedge a portion, or none, of the US$1,060 horizon investment value, choosing to bear some of the exchange rate risk. For example, if 50% of the exposure is hedged, the investor agrees to exchange $530 at the forward exchange rate of 0.994 but allows $530 to remain unhedged. If the spot exchange rate one year from today is greater than 0.994, the German investor benefits as he will receive more euros when converting at that higher exchange rate than he would have received by investing directly in the German government bond, and vice versa.

The Multi-Currency module in BondEdge includes reports that allow you to compute the percentage of a portfolio’s value represented by each currency on both a hedged and an unhedged basis for easy monitoring of your currency exposure. We hope this brief review of hedging exchange rate risk has been useful. If you have comments or suggestions for other Back-to-Basics columns, please contact marketintg at (310) 479-9715, or by e-mail at fia.marketing@interactivedata.com.


1See "International Investments", by B. Solnik, 3rd edition, p. 36 (pub. by Addison Wesley, 1996).