Hedging Currency Exposure

The disadvantages of hedging

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Hedging Currency Exposure

Global markets provide international investors a large array of opportunities, not only for exposure to their respective economies, but also to specialist sectors within those markets.

The following chart shows global stock markets priced in US Dollars. Not only is the US the worlds largest economy, it has one of the worlds strongest currencies and also houses the powerful return generator of its technology sector. Since January 2007 the US S&P 500 has outpaced all other global stock markets. It's a worthy place to be involved.

For many investors however, moving away from home markets can be unnerving. Unfamiliar companies, access to brokerage accounts, expense, currency exposure and the 'great unknown' can make it all seem too hard.

However, with some research and a little practice, access to foreign markets can be quite simple. The focus of this article is managing the all-important currency exposure.

As an Australian looking to invest in US securities I need to buy US assets. To do so I must convert my home currency, Australian Dollars (AUD), to US Dollars (USD).

The risk is while holding those US securities, the AUD could rise against the USD. That will result in a currency loss when I eventually reverse the transaction, and any currency loss will eat into my strategy performance. Of course if the AUD falls I will get some added gains.

My goal therefore is to mitigate the possible loss or risk of the AUD rising so I need to hedge that exposure.

An important element here is that a hedge is not designed to generate a profit. It is designed to protect the portfolio. The impact of a hedge needs to be measured together with the strategy P&L.

Some of the disadvantages of hedging are:

  • can become complex and may require separate accounts
  • can be expensive
  • can morph into its own trading regime

My preferred hedge vehicle is Australian Dollar futures traded on Globex (CME). The underlying contract value is AUD$100,000. The Initial Margin requirement is US$3,375 per contract making it inexpensive. AUD futures contracts trade in 3-monthly intervals so using a deferred settlement I can hold a position for 6+ months with ease.

My brokerage account allows me to access futures contracts right alongside my securities holdings.

Next I make the hedge mechanism simple and only protect against large moves. If I get too involved in smaller moves, i.e. the noise, then my costs and workload increase and the hedge becomes a beast unto itself.

There are many ways to trigger a hedge. Methods that could be considered are a breach of an upper Bollinger Band, a 10-month moving average cross, or a 40/200 or similar moving average cross. No one method will be perfect and all will suffice if the focus is on larger moves and steering clear of short term noise.

I prefer a monthly close above (below) the 100-day high of the AUDUSD pair (see chart below). So, my process is:

  1. If the AUDUSD closes above the 100-day high at month end.
  2. Buy the 6-month or 9-month deferred Australian Dollar futures contract equal to the value of the home currency exposure.
  3. If the portfolio is exited whilst the hedge is on, then exit the hedge.

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IMPORTANT INFORMATION

Commodity Futures Trading Commission (CFTC) Rule 4.41

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

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