The various models of exchange rates are as follows:- (a) Covered Interest Rate Parity (CIRP). This relates to spot and forward exchange rates to nominal interest rates. The advantage arises from the arbitrage opportunity. (b) Unbiased Expectations Hypothesis. As the name suggests the time to forward rate is an unbiased predictor of the future spot rate. (c) Uncovered Interest Rate Parity. This caters for the return on lending abroad versus return from lending domestically.
Thus expected return to lending abroad should equal the risk free return from lending domestically. International Portfolio Returns This is based on the hedged return being equal to the local return plus interest cost of hedging, in which the interest cost of hedging is equal to the positive cost for investors with a low interest rate home currency and negative cost for investors with a high interest rate home currency. International Equivalence of hedged Excess Return These are hedged return minus domestic risk free vis a vis local excess return.
These are thus independent of the currency perspective. Hedged Plus Cash Decomposition This involves analysis of the hedged units plus foreign/domestic cash positions thus providing benefits to plan portfolio strategies as well as risk management. Unit Adjusted and Optimal Hedge Ratios This unit hedge strategy is a sub optimal strategy as it does not account for the expected excess return on foreign equity, co variances between equity returns and currency returns and expected excess returns on currencies.
Adjusted Hedge Ratio and Hedge Slippage Strategy This ignores the expected excess return on equity and hedge slippage, which can occur due to movements of stock prices which can be lowered but cannot eliminated by taking out the expected excess return from the equity portfolio.
Risk Minimizing Hedge strategy In this the unit hedge and capital gain adjusted hedge ignores the covariance between the currency and asset returns in the risk analysis and the advantage of currency/asset covariance by using variance minimization is undertaken to chose hedge.
Mean variance Optimal hedging This overcomes the shortcoming of the strategy stated above by mean variance optimization of the currency hedge. Currency Hedging Currency hedging problem is known as a peso problem as the relationship between variables is difficult to measure as one or more of the variables is subject to large and infrequent oscillations. Reliable inference in currency markets is difficult to achieve as optimal risk forecasting and risk management is difficult.
There are a number of approximate methods which have been evolved for attaining a total return on foreign investment into local returns which can be currency unrelated or currency only returns. A portfolio needs to be multi based on a number of factors, a local risk component, a currency risk component and a component in which the co variances between the local and the currency returns are measured. Currency hedging is not only essential when a large fraction of a portfolio is allocated to foreign assets but also for small asset allocations as the minimum risk hedge ratio does not necessarily increase only with the exposure to foreign assets.
Per unit exposure is more relevant to hedge the currency risk for small allocations of assets in foreign currency than for large allocations. In fact in some cases even for portfolios with no foreign assets there may be a necessity for currency hedging. . It needs to be understood that volatility and foreign asset exposure will take on only positive values and minimum risk hedge ratio increases as a function of the foreign asset exposure as it is not likely that the returns of the currency forward contract are inversely correlated with the returns of the domestic asset.
Since bond returns and currency returns domestically tend to move inversely with the interest rates domestically and profits of companies also vary with currency fluctuations, hence currency risk of portfolios needs to be hedged. Currency Risks in Contracts A financial futures contract obligates a seller to pay the value of the contract to the buyer at a specified date. The financial futures contracts have uniform terms for the quantity, expiry date and the asset. A forward contract on the other hand is negotiated privately.
These can be very effectively used to control the risk by changing the asset mix without disrupting the assets per se. Systematic risk can be hedged away and short and long positions from the portfolio can be exploited to extract alpha. Currency risk can be removed from an internationally managed portfolio by effectively hedging the currency exposure. In international trading it is important to manage the currency as well as the portfolio risks simultaneously. Impact of National and Global effects on Capital Markets
There are various views prevalent on the impact of national and global effects on the stock market. Some feel that country effects are more important than industry effects, while national stock markets are seen to dominate global factors in explaining returns. While some others tend to view global and national influences as of equal importance. In equity and bond returns however national influences are said to be the most powerful. Each model thus has to be carefully analyzed and realistically applied in the given context.
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