Currency Hedge Costs Do Not Equal 'Interest Rate Differentials'—The Structural Divergence Created by Spot-Forward Spreads and Basis
Introduction
When explaining hedged foreign bond funds, the phrase “currency hedge costs are roughly equal to the interest rate differential between Japan and the U.S.” is widely used. It is concise and sounds plausible. It is not entirely wrong, either. I acknowledge the convenience of this explanation.
However, there are questions that cannot be answered with this explanation alone. For example, “Why did hedge costs rise since last month even though interest rates haven’t moved?” Or, there are times when people ask, “Will costs go down if rate cuts begin?” If you have been explaining costs using only the term “interest rate differential,” you will find yourself stuck for an answer here.
What is actually paid as a currency hedge cost is not an abstract figure called an interest rate differential. It is the difference between the exchange rate for an exchange made now and the rate reserved for a future exchange. The former is called the spot rate, and the latter is called the forward rate. The difference between the two is the spot-forward spread. The true nature of hedge costs lies in this observable price difference.
The interest rate differential is merely the primary ingredient that creates this price difference. There is one more ingredient. It is the premium added when there is a rush of people wanting to procure dollars, known as the currency basis. Even if interest rates do not move, this premium does. This is why you get stuck on the questions mentioned at the beginning.
The danger of stopping at “roughly the interest rate differential”
Approximating with an explanation is not a bad thing in itself. The problem is when it takes on a life of its own without being recognized as an approximation. If you do not know the situations where the approximation breaks down, you will be unable to continue your explanation when costs move suddenly.
Opportunities to discuss hedge costs have increased over the past few years. This is because the state where short-term dollar interest rates significantly exceed those of the yen has continued, creating an environment where the nature of products is clearly divided by the presence or absence of a hedge. The level of the cost itself has become a factor in product selection. Yet, how these costs are determined is surprisingly rarely discussed. Talking only about the level without knowing how it is determined is like deciding whether or not you need an umbrella without looking at a weather map.
And the moments when explanations fall apart are invariably when the client is feeling anxious. When the yield after hedging suddenly deteriorates. When costs spike at the end of a period. Whether or not you can continue the conversation by explaining the structure at those times determines the trust placed in the solicitor.
Three questions I want to answer
I will answer three questions in order. Where does the substance of the cost lie? To what extent does the alignment with interest rate differentials hold, and where does it break down? And how do you translate this into explanations for hedged foreign bond funds or foreign currency-denominated insurance?
Once you get down to the third question, you will be able to talk about the dangers of saying “it’s a good deal because of high interest rates” not as a feeling, but as a structure. I will verify this step by step using calculation examples with hypothetical settings.
I should state in advance that all numerical examples in this text are hypothetical settings. Since actual levels change daily, what I want you to remember is not the numbers, but the way they are determined. As long as you have the method of determination at hand, your explanation will not fall apart even if the levels change. Conversely, an explanation that only memorizes the levels will become obsolete the moment the market moves.
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I will first summarize the difference between common explanations and the actual structure in one table.
Table 1: The explanation of “Interest Rate Differential = Hedge Cost” vs. the actual structure
If you stop at the explanation in the left column, you will be unable to continue your explanation when the movements in the right column occur.
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