Roll Yield

When it comes to investing, the goal is to buy low and sell high. It's not really that simple, but that's what investors are trying to do. So when it comes to forward currency contracts, the forward points added to the spot price can lead to there being a forward premium or discount. So if you apply the common investing goal, which action would typically lead to a gain?

Right! If the forward contract is selling at a premium, then you can sell the contract and probably earn a gain. That's selling high, and when it comes to forward contracts, you'll want to make sure you keep the "buy low, sell high" idea in your mind, especially when it comes to __roll yield__. Roll yield is the gain or loss that results from rolling forward a forward contact.

That's not it. It's trading at a discount, so it's on sale, which means you should buy it.

No. You want to sell low, so you'd sell the low-yield currency.

For example, a positive roll yield will result when you buy the forward contract at a discount and sell it for a premium. Basically, that means that your long currency exposure appreciated relative to your short currency exposure. But many times, asset managers have to pay a premium for the forward contract and, as time passes, that long currency position doesn't appreciate past the premium paid. Then it comes time to roll that forward contact forward. What's the result to the portfolio?

No. You'd paid a premium to hedge the currency risk, so that premium can result in a gain or loss.

No. A gain means that the long currency position appreciated.

Clearly, yes! Since a premium was paid and the currency didn't appreciate past the premium point when the contract expired, you essentially have a loss that's reflected in the nominal value you'll receive and then use at the time you initiate a swap to roll forward the forward contract. That's negative roll yield, and it can be self-perpetuating as asset managers pay consistent premiums to roll forward forward contracts.

Essentially, you can think of a positive roll yield as part of the carry trade and forward rate bias strategies. Just like you buy the forward discount currency and high-yield currency, you'll want to make sure you try to buy at a forward discount. So basically, trading a negative roll yield is the exact opposite of trading the forward rate bias. Roll yield is also an important concept for equity forwards and futures, fixed-income securities, commodities, and really, any financial product. So if the product is in contango, then there's a good chance that the roll yield will be negative.

This contango concept also helps explain how forward points impact the amount of currency hedging. For example, it's much easier to sell a forward contract when the forward points provide some room to make a profit. So which situation is most likely to result in more currency hedging?

No. You don't want to sell something that's trading for a discount.

Exactly! Buying currency forward at a discount leaves some room for the currency to appreciate and provide a positive roll yield. This will help returns, and it makes it easier to hedge the currency. So more asset managers will hedge currency risk when the forward points are priced to help their exposure. Asset managers will also be much more likely to hedge if their analysis shows that hedging will produce the best outcome.

Not quite. That's not going to encourage more currency hedging.

That may seem obvious, and in reality it is, but it's smart to think through what this means in practice. For example, suppose you need to sell forward the base currency and believe that the expected roll yield is -2%. If you anticipate the base currency will depreciate by 4%, what's your best course of action?

That's it! Even though your roll yield is negative, you also believe that the market is mispricing the forward points versus your anticipated 4% decline in the base currency. So you'd hedge your exposure and take the -2% roll yield. But if the situation was reversed and your prediction for the base currency was for it to depreciate less (or appreciate more) than the roll yield, you actually need to spend some time analyzing the situation. That's because risk-tolerant investors may let the situation play out, while risk-averse investors may still pay more to guarantee a certain loss. Why would risk-averse investors take a guaranteed loss versus market expectations?

No. You have a clear market view, so trade on it.

That's not it. That's probably going to result in a loss of 4%.

Exactly. Market expectations could be wrong, and the loss from an exposed currency position could be greater than the roll yield loss. So risk-averse investors may decide to take the guaranteed loss in knowing that the unhedged loss could be much worse. Likewise, the return on the unhedged position would have to be pretty substantial when compared to the roll yield to make risk-averse investors accept unhedged currency risk. Clearly, the decision will vary among different investors, but in general, the higher the cost of the hedge, the more it becomes beneficial to not hedge. Similarly, if the hedge involves buying the high-yield currency and selling the low-yield currency, then the hedge becomes more likely.

No. That's not a good way to think about risk. Risk needs to be a comprehensive approach.

Not really. If there's only a desire for the known, then risk shouldn't be taken because risk is the compensation for the unknown.

To summarize: [[summary]]

Selling the forward premium

Selling the forward discount

Buying the low-yield currency

There will be a loss

There will be a gain

It's already currency hedged

Selling currency forward at a discount

Buying currency forward at a discount

Buy currency forward with no discount or premium

Hedge

Split the difference

Remain unhedged

Market expectations could be wrong

The loss can be made up in other areas

The known is always better than the unknown

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