Lesson 8 of 8 · All lessons in this module
- Risk, risk exposure and what risk management is
- The risk management framework
- Risk governance and the enterprise view
- Risk tolerance and risk budgetingVideo lesson
- Financial and non-financial risks, and how they interact
- Risk drivers and risk metrics
- Modifying risk: avoid, accept, transfer or shiftVideo lesson
- Integrated case: hedging the currency of a foreign bond holding
Lesson 8 of 8 · 15 min
Integrated case: hedging the currency of a foreign bond holding
A forward hedge removes the currency leg from the three-asset variance formula and shifts expected return by the forward premium or discount, but because the holding keeps changing in value the hedge is never exact.
In short
- Unhedged, a foreign bond is three exposures (equity, bond in local currency, currency); a 100% hedge deletes the currency from the variance formula and leaves the two-asset formula.
- The expected-return effect of a forward hedge is hedged weight × (forward − spot) ÷ spot. Forward and spot differ because of the deposit-rate gap between the two currencies.
- A hedge does not always lower portfolio risk: if the currency is negatively correlated with the rest of the portfolio, it diversifies and removing it can raise risk.
- A forward fixes the amount sold. The bond's value moves, so the position becomes under- or over-hedged and must be reviewed, trading monitoring and transaction costs against risk.
- Selling a currency forward is risk shifting (a derivative), not transfer through insurance and not avoidance.
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