How to hedge currency risk
Inherently, an international investment will expose an investor to currency volatility. So, we’ve taken a look at some of the considerations for hedging foreign exchange exposure.
How do exchange rates affect currency returns?
Exchange rate movements impact returns when a change in the value of one currency against another currency leads to a rise or fall in the value of an asset. When an investor buys a domestic asset, the only variable is whether that asset increases in value. But if they invest abroad, they will have to consider the impact of an exchange rate too. The basic function of this is relatively simple: when a local currency depreciates, it can buy less of a foreign currency, decreasing its purchasing power. And when a local currency appreciates, it can buy more of a foreign currency, increasing its purchasing power.
For example, let’s say you want to invest in a (fictitious) French clothing company, Paris Prints. Shares of the company are trading at €50 – so at the current EUR/GBP exchange rate of 0.9004, you’d be paying £45.02 (50 x 0.9004) for the stock. If you bought 100 shares, your initial outlay would be £4502.
However, you don’t execute your order for two days. Although the share price of Paris Prints has remained the same, a Brexit announcement caused the pound to depreciate against the euro. So, at the new exchange rate of 0.9250, you’d be buying the shares at a higher price of £46.25, giving you an outlay of £4625.
Although the value of the asset has not changed, the local currency has depreciated, so foreign investments are more expensive to purchase. This dynamic means whenever an exposure exists to a foreign currency denominated asset, currency risk exists and needs to be managed.
How to hedge GBP against foreign exchange risk?
To start hedging foreign exchange risk, you should:
- Conduct research. Learn about financial markets with IG Academy’s range of online courses
- Practise your hedging strategy. Trade in a risk-free environment using an IG demo account
- Start hedging your currency risk. You can open a live trading account in minutes with our simple online form
With Brexit uncertainty playing on the minds of UK and EU-based investors, it’s easy to see why hedging GBP exposure has become a large topic of conversation since the 2016 referendum. But, as with any other element of a financial plan, there’s no golden rule as to how one should hedge their GBP currency risk.
There are simply too many unique variables that must be considered to effectively match a hedging strategy to an individual’s financial goals. However, there are certain products and principles that can be utilised to ensure that currency risk is appropriately managed and aligned with such goals. These include:
An important consideration to make when managing currency risk is that by opening forex positions to balance foreign exchange exposure, you’re taking on the risk of these additional positions. There will be different requirements for hedging forex positions themselves.
Hedging currency risk with specialised ETFs
While less conventional, one way to hedge foreign exchange risk is by investing in a specialised currency exchange traded fund (ETF). In principle, a currency ETF functions just like any other ETF, but rather than holding stocks or bonds, it holds currency cash deposits or derivative instruments tied to an underlying currency, which mirror its movements. For example, the ProShares UltraShort Euro ETF or the PowerShares DB US Dollar Index Bullish Fund.
A trader can go long or short on these ETFs, depending on the required hedge, to protect the value of an investment or cash flow from a currency’s (or multiple currencies’) volatility.
Hedging currency risk with CFDs
A contract for difference (CFD) is a derivative that can be used to hedge foreign exchange risk – to open a CFD position, the trader is not required to own the underlying currency. A CFD hedge works because you are agreeing to exchange the difference in price of an asset – in this case currency – from when the position is opened, to when it is closed. If the market moves in the direction the trader predicted, they would profit and if it moved against them, they would lose.
A CFD position can be used to offset the currency exposure of the asset being hedged. Because CFDs are a leveraged product, only a small amount of capital is required to enter the hedge. Furthermore, the hedge can be closed via cash settlement, limiting the potential financial outlay of the trade.
Hedging currency risk with forward contracts
A forward exchange contract (FEC) is a derivative that enables an individual to lock in an exchange rate in the present for a predetermined date in the future. The benefit of a forward is that it can protect an individual’s assets from exchange rate movements by locking in a precise value now. The cost or benefit of buying a forward is known at its purchase, with the forward exchange rate calculated by discounting the spot rate using interest rate differentials.
Hedging currency risk with options
An option gives the right, but not the obligation, to exchange currencies at a pre-determined rate on a pre-determined date. There are two types of options: puts and calls. A put option protects an option buyer from a fall in a currency, while a call option protects an option from a rally in the currency. The benefit of such a strategy is that, for a premium, an individual can protect themselves from adverse movements.
How to hedge a property being sold overseas?
Foreign exchange risk can impact overseas property assets, and potentially erode their returns in the event that the value of a currency moves against you.
A popular approach to hedging the sale of an overseas property is to fix the value of the sale using an FX derivative – such as a forward exchange contract – immediately after the sale of the property is settled. This means locking in the exchange rate for the sale (and the income generated from it) at the point at which it is confirmed, so that the return achieved is made certain and is protected from any potential adverse moves in exchange rates.
However, other derivative products can also be used to hedge property prices – such as CFDs. This strategy would involve opening a CFD position on a forex pair, so that any profit to that position balances out or partially reduces the decline in the property returns.
Let’s say you’re a UK-based investor, who is planning to sell a property in Spain in six months. At the current EUR/GBP exchange rate of 0.89800, your €245,000 villa is worth £220,010 (245,000 x 0.89800). You’re concerned that the pound will strengthen against the euro, which would lessen the value of your foreign investment.
To hedge your foreign exchange exposure, you decide to take out a short EUR/GBP CFD – buying the sterling while selling the euro. One EUR/GBP contract is worth €100,000 so you would need to take an exposure equivalent to 2.45 contracts to balance the currency exposure of your €245,000 villa. For IG clients, one contract is the equivalent of £10 per point, so 2.45 contracts would give you 24.50/per point. You’d open your position to sell EUR/GBP at the current bid (sell) price of 0.89790.
Once you’d placed your short CFD trade, if the pound did strengthen against sterling, the profit to the CFD position would mitigate some of the loss in value of the property. If the price of EUR/GBP fell, you might decide to close your trade at the ask (buy) price of 0.87800. The market would have moved by 200 points in your favour – earning you £4900 (200 x £24.50).
At the same time, the price of your property would have been adversely impacted by this decline in the value of EUR/GBP. At the new spot price of 0.87800, your Spanish villa would be worth £215,110 – a loss of £4900. This loss would now have been hedged by the profit to your short CFD trade.
Had your prediction been incorrect, and the pound did not appreciate, the loss to your CFD trade could be partially offset by the advantageous exchange rate on your property sale.
How to hedge an overseas salary?
Hedging an overseas salary can be more complex, because the hedge relates to ongoing cash flow. This means that the exposure exists over a longer timeframe, and therefore the investor is exposed to greater risk and volatility.
For the passive and risk averse, it is possible to calculate one’s annual salary and take out a block-hedge that covers the entire salary against currency fluctuations. For example, with a forward contract, you’d buy the currency now and pay for it after 12 months. This can bring exchange rate certainty, but it also runs the risk of ‘over-hedging’.
For the active types, a ‘rolling hedge’ can be used to try to maximise currency returns, while protecting from downside risk. This is a strategy that uses a combination of hedging products with expiry dates, such as futures or options. As time ‘rolls’ by, and expiry dates are reached, a new position would be opened with the same conditions but a new maturity date. The position sizes could be increased or decreased depending on whether exchange rates move favourably or unfavourably.
Hedging currency risks summed up
Currency risk can rapidly erode profits, especially in times of high volatility. As a result, when exposing oneself to overseas markets, whether that be through a traditional investment, a sale of a property, a commercial purchase, or receiving income, a view needs to be taken about currency risk. Some may feel comfortable with the risk of exchange rate volatility, and wish to try to take advantage of it. Others would prefer not to have such uncertainty. In any event, the risks associated with foreign exchange ought to be considered to ensure one’s personal objectives are not compromised.
To start hedging currency risks, there are a few steps every trader should follow. These are:
- Understand the basis of your financial goals and objectives
- Identify where FX exposures exist, and how they may impact your objectives
- Quantify risks, stress test and perform some scenario analyses
- Make a judgement on your appropriate risk appetite
- Find a hedging style and strategy that fits in within your risk appetite, and aligns with financial goals
- Match the appropriate hedging products to this strategy
- Monitor, assess and amend your hedging strategy as circumstances change
If you feel ready to start hedging your currency risk, you can open an account with IG in minutes. However, if you want to build your strategy in risk-free environment first, you can create an IG demo account.
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