Hi, Please can someone explain what the following means, in layman's terms (Chapter 23 - Page 3, talking about disadvantages of currency swaps): - Mismatching real liabilities by eliminating purchasing power parity protection against unexpected inflation differentials. I interpret it as any adverse inflation rate movements on the underlying liabilities can no longer be offset by any favourable currency movements, as exchange rate movements have been hedged against. I feel like I am not exactly there with this so any explanation will be helpful. Thanks
Hi, I would say you were bang on in your description. If an institution buys overseas assets, there is a natural inflation hedge. As you say, when UK inflation is high, and liabilities rise steeply in cash terms, the UK currency would be expected to be weak (PPP) and therefore the overseas asset would benefit from a currency gain. By hedging the currency, this no longer works as the institution has hedged any currency gains.
