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Trying to think about the right way to hedge a EUR denominated issuance from FX risk only. Say I have an annual pay 20-year EUR bond and I want to hedge the FX risk but take the interest rate risk. I would be hedging using forwards, say 3m.

What value of the bond should I hedge, present value or future value?

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  • $\begingroup$ For perfect hedging of all FX risk you would have to hedge each of the coupon payments and the final principal payment as well. This would require 20 forwards ranging from 1 to 20 years, or perhaps a currency swap with 20 year maturity. $\endgroup$ – noob2 Apr 1 '16 at 18:18
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You need to hedge future cash flows (not future value) using a fixed for fixed currency swap (equivalent to a series of forwards). This translates into a "cash flow hedge". Hedging present value would be hedging the "fair value" of the bond with a fixed-for-float currency swap. Using a fixed for fixed swap will convert your cash flows into desired currency (e.g. USD or GBP) and will convert EUR interest rate risk into that currency's interest rate risk. Hence you will not "hedge" your interest rate risk, but you will convert it from one currency's interest rates to another. It is impossible to have cash flows in one currency and interest rate risk based off of a different currency.

If your bond is variable rate you can use a basis swap to achieve the same type of cash flow hedge as before. If you use a float-for-fixed swap you will convert this into a interest rate hedge as well.

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To hedge the EUR value without interest rate risk then you'd use the net present value of the EUR face value you receive at maturity, and add the NPV of all the discounted future cash flows, right?

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  • $\begingroup$ So I think that means you would hedge the NPV of the bond itself, which essentially means the current market value. $\endgroup$ – Alex C Apr 2 '16 at 16:08

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