Hedging is a strategy used as a means of removing or at the very least reducing the uncertainty of exchange rate fluctuations on your portfolio returns. The method you employ to hedge your portfolio will depend on a variety of factors.
The first step in choosing a hedging strategy is to quantify your exposure.
For the sake of simplicity let’s assume you have converted A$ 110,000 into US$ 100,000 (based on an exchange rate of AUD/USD 0.9091) in order to purchase a US equity portfolio of US$ 100,000. What is your exposure? What if the value of your US portfolio falls to US$ 90,000 or rises to US$ 110,000? What about interest earned or dividends received? How long do you plan to hold this US$ denominated portfolio?
These important but simple questions indicate that hedging is often not simply a set and forget strategy. It needs to be monitored regularly.
Once you have calculated your exposure, you will need to determine how much of this exposure you wish to hedge. This decision will be a function of your tolerance for risk and the cost of protection. More conservative investors will hedge 100% of their exposure, while others will choose not to hedge the full amount or not to hedge at all.
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Once the exposure is identified and the amount of protection has been decided, you have a choice of forward exchange contracts (FECs) and currency options or a combination of both.
Before any decision is made, understanding the characteristics of FECs and currency options is important:
– The purchase of an option will require a payment of a premium up front while a FEC does not;
– An option allows you to profit from favourable movements in the exchange rate while protecting you from adverse exchange rate moves. A FEC also eliminates adverse risk but does not allow you to participate in any favourable exchange rate movement; and
– An option needs only be exercised if profitable while you must deliver or close out an FEC.
Let’s consider the following where we look at the implications of an appreciation in the AUD against the USD.
Assume the following market rates:
Spot AUD/USD 0.9150
6 month FEC rate 0.8915
6 month AUD call (US$ put) with an out of the money (OTM) strike at 0.9300 at 1.96% premium cost of the US$ amount.
In six months time the AUD/USD has appreciated to 0.9500.
If you had sold US$ 100,000 FEC at 0.8915 as a hedge, you would receive A$ 112,170.50 in six months time. Compare this with an amount of A$ 105,263.16, (i.e. US 100,000 at AUD/USD 0.9500) if you were unhedged.
If you elected to purchase the OTM option rather than doing a FEC or leaving the position unhedged, the premium cost would have been US$ 1,960.00 (or A$ 2,142.08 at AUD/USD 0.9150). As the exchange rate in six months time is higher than strike price of 0.9300, you exercise the option.
The effective rate achieved is USD 100,000 / AUD 105,384.80 (US$ 100,000 converted at 0.9300 less A$ 2,142.08 premium paid) or 0.9489. Only a slight improvement than the current rate of 0.9500.
Clearly in this scenario the outright purchase of the FEC is vastly superior to the OTM option.
In six months time the AUD/USD has depreciated to 0.8500.
If you had sold US$ 100,000 FEC at 0.8915 as a hedge, you would receive A$ 112,170.50 in six months time. Compare this with an amount of A$ 117,647.06, (i.e. US 100,000 at AUD/USD 0.8500) if you were unhedged.
If you elected to purchase the OTM option rather than doing a FEC or leaving the position unhedged, the premium cost would have been US$ 1,960.00 (or A$ 2,142.08 at AUD/USD 0.9150). As the exchange rate in six months time is lower than strike price of 0.9300, you would not exercise the option as entering at the current market price is more advantageous.
The effective rate achieved is USD 100,000 / AUD 115,504.98 (US$ 100,000 converted at 0.8500 less A$ 2,142.08 premium paid) or 0.8658. This is a significantly better rate than the FEC.
In summary, the decision of what hedging alternative to use is similar to buying insurance. You need to evaluate which hedging strategy provides the appropriate level of protection at the most acceptable cost.