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How Forward FX Hedging Can Turn a Negative-Yield Bond into a Positive Dollar Return

Article Quant Q&A · Author: TmSmth
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Summary

The document explains how a US investor can hold a euro-denominated German bond while hedging the currency exposure. The investor exchanges dollars for euros at spot, buys the bond, and sells euros forward to lock in the dollar value of the maturity proceeds. Although the bond’s negative yield reduces its euro value, the forward exchange rate can more than offset that decline when short-term interest rates are higher in dollars than in euros.

An illustrative calculation applies the bond’s stated yield and the quoted spot and forward rates to a dollar investment, producing a positive annualized dollar return. The explanation shows how the hedge affects total return, rather than changing the bond’s euro yield. Its figures are tied to market rates at the time of the example, and the answer notes that changing rates make its calculation differ from the cited article. It does not quantify transaction costs, collateral, or other implementation effects.

Key ideas

  • A currency hedge can be formed by buying euros at spot and selling them forward against dollars.
  • The forward rate locks in the dollar proceeds from the euro bond at maturity.
  • A favorable forward premium can offset the bond’s negative euro yield.
  • The example’s calculated return depends on the specific market rates used.

Tags

Fixed incomeForexCarry
Full text
# Hedging EURUSD with negative rates


# Hedging EURUSD with negative rates












I was reading an article and i saw this :

> Fund managers based outside the eurozone can profit from buying Europe’s negative-yielding government debt thanks to an uplift from hedging the currency. That is because such hedges are based on the relative levels of short-term interest rates. These are much higher in the US than in the euro zone, meaning dollar- based investors are effectively paid to hedge their euro exposure back into dollars. For instance, a two-year German Bund currently yields around minus 0.88 per cent. However, after hedging the currency, this becomes a positive yield of around 1.9 per cent for dollar-based investors. For a US-based investor, this is better than buying a two-year Treasury.

I don't understand the reasoning behind this. If you convert USD to EUR, then buying negative yield bond in eurozone, you lose money. How hedging the currency can counter balance it ?

## Answer by Alex C (score 5, accepted)

https://quant.stackexchange.com/a/48774

For a US investor to hedge the bonds the investor would (1) Buy EURUSD in the Spot market, (2) Buy the German bonds with the EUR proceeds, (3) Short EURUSD in the forward market to provide a guaranteed repatriation rate when the bonds mature (thus avoiding FX risk).

Currently the two year forward exchange premium/discount for the EURUSD is 532 forward points (source) and the spot rate is 1.1052 (source) so the two year forward rate is 1.1584.

Let's say I start with 1000 USD, I exchange it for 1000/1.1052 = 904.8136 EUR. I buy the German bonds. In two years I expect to have 904.8136*(1-0.0088)^2 = 888.95895 EUR because of the negative interest rate. This will give me 888.95895*1.1584 = 1029.77 USD. In dollars I have made a profit of 29.77 or earned a yield of about 1.47% a year).

[The rates have been changing recently, so it does not quite match the calculation in your article].

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.