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Academy #6 Interest rates, currencies & hedging

Academy #6 Interest rates, currencies & hedging. Get connected to B&R Beurs @. Current News. “Europe’s Central Banks Diverge on Path” -The Wall Street Journal

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Academy #6 Interest rates, currencies & hedging

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  1. Academy #6 Interest rates, currencies & hedging Get connected to B&R Beurs @

  2. Current News • “Europe’s Central Banks Diverge on Path” -The Wall Street Journal • „Forthefirst time in a long time, youdon‘thavetobe an optimisttoseetheglassas half full.“ –Mark Carney Bank of England • „Employing unusually sharp language, the U.S. on Wednesday openly criticized Germany's economic policies and blamed the euro-zone powerhouse for dragging down its neighbors and the rest of the global economy.” -WSJ

  3. Current News

  4. Current News

  5. Current News

  6. Current News

  7. Current News

  8. Hedging • Definition:“Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.”

  9. Hedging • Definition:“Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.”

  10. Hedging • Example: • We think Adidas will do better than the market • But we do not wanttobet on theoverallmarket • Whatcanwe do?

  11. Hedging • Let’s look at data:

  12. Hedging • Let’s look at even more data: • What can we do?

  13. Hedging • Hedged position in Adidas:

  14. Foreign currencies as a risk factor • Currency risk: additional volatility after transforming returns of a foreign investment in our domestic currency compared to returns measured in local currency

  15. Foreign currencies as a risk factor Source: datastream • Volatility in EUR: σDAX,EUR = 23.83% • Volatility in CHF:σDAX,CHF= 26.26% • CurrencyRisk : σDAX,EUR -σDAX,CHF= 2.43%

  16. What is currency risk? • Currency risk is not the volatility of the FX-rate! • In previous case: σCHF,EUR= 7.22% • Why is currency risk lower?  Imperfect correlation between DAX returns in EUR and CHF/EUR FX-returns (0.2)

  17. Currency risk differs among asset classes & currencies (1) • Large increase of volatility for bonds Source: datastream, bloomberg 1999 -2012

  18. Currency risk differs among asset classes & currencies (2) • Smaller (proportional) increase in volatility • Large currency risk for Australian Dollar Source: datastream, bloomberg, yahoo 1999-2012

  19. Currency risk differs among asset classes & currencies (3) • Commodities: for EUR-investor negative! • Hedge Funds: high currency risk Source: bloomberg 1999-2012

  20. Currency risk differs among currencies • Safe haven currencies (e.g. USD & JPY) tend to appreciate when int. stock markets fall  May provide a natural hedge

  21. Currency risk differs among currencies • AUD & CAD tend to depreciate when int. stock markets fall (pos. correlated)  mostly better off hedging them

  22. Currency hedging in a portfolio • Two approaches in practice 1. Hedging according to asset classes: practitioners‘ approach: hedging foreign bonds but not foreign stocks  easy to implement, but neglects correlations 2. Currency Overlay: Currencies are hedged regarding their correlation with the total portfolio  requires permanent analysis

  23. Currency hedging in a portfolio • Assume a portfolio with two domestic assets

  24. Currency hedging in a portfolio …and now one with two foreign assets • Hedging according to asset classes ignores 3 out of 6 correlations!

  25. To hedge or not to hedge? • Investing in global stocks as an European investor

  26. Why invest in bonds? • bonds pay interest periodically and provide a predictable income stream • to diversify risk • to preserve the capital investment

  27. Bonds ≠ Stocks • Unknown upside potential • You can benefit from this • Unknown downside potential • Usually lower than in case of a bond default • Limited upside potential • You get the coupon and principal • In case of default • Large part of the investment is lost • Special attention to ratings when buying a bond

  28. What determines the bonds characteristics? • Credit risk: How likely is that the issuer will actually repay? • Term: How far in the future are the payments? • Strongly related to inflation risk and changes in the key interest rates! • Seniority: What is my payment priority when the company actually defaults or goes out of business

  29. Yield • „Interest rate thatsetsthecurrentpriceofthebondequalto all thefuture cash flows“ • So itisthesolutiontothefollowingeqution: • It is a standardized way to compare prices

  30. Interest rate risk • Interest rate risk: - captures the effect of changes in the market rate of interest on investment value - affects more the value of bonds - when interest rate rises, bond value (price) falls

  31. Term Structure

  32. Term Structure • Term structure is not constant

  33. Interest rate risk - Bonds (1) • Interest rate risk is approximated by duration (the % change in the security price for a 1% change in yield) • Duration can also be seen as the average time until you get the payments • For a zero-coupon bond: duration = maturity

  34. Interest rate risk – Bond (2) • A bond with higher duration is perceived as more risky • Lower coupon -> higher duration • Longer maturity -> higher duration

  35. AnyQuestions?

  36. Hedging • Hedged position in Adidas:

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