Question

Hedging currency risk with a forward.

Assume you are a US-based speculator and you want to bet on the UK 10 year zero nominal bond. Assume you buy the UK 10-year bond, but also need to hedge out your currency exposure (i.e. you do not want exposure to changes in the USD vs. GBP fx rate).

You decide to hedge your fx exposure by selling GBP 10 years forward.

You now how two legs to your trade: buy UK 10-year bond and sell GBP 10 years forward.

Question 1: describe your what market forces your overal bet is exposed to when you initially put the trade on? Essentially, what market forces will drive P&L?

Assume you don't need to describe how you funded the trade (i.e. how you got the USD to buy the bond is not in scope). Ignore counterparty risk, default risk, and bid/offer spreads. Assume everything settles on the trade date T. Only explain market forces when you initially put the bet on, not the entire life of the 10-years.

Answer 1

Zero nominal bond will make a fixed balloon payment at the end of the period (10 years). Forward contract will be settled then. The actual exchange price of USD/ GBP will depend on the 10-year view of the exchange rate and availability of buyer at that price. The exchange rate will depend on the long term inflation outlook of the 2 countries. The inflation outlook will also drive the interest rates in both the countries. Interest rate for 10-year government bonds can be used to base our views and to find the forward contract prices. The interest rate parity principle will be govern the expected forward price. Short term factors will not affect much in pricing the forward contract since the settlement is after 10 years.

Actual currency exchange gains or losses will depend on the actual exchange rate of the currencies at the time of settlement. This rate will be governed by multiple short term factors, including demand and supply of the two currencies.