Hedging Currency Risk (Part 2)

Hedging Currency Risk (Part 2)

In the first part of this series (here) I talked about the various options for a small time investor to hedge currency. In this article I will say how I intend to test these against each other and detail the exact transactions I have performed.

The three methods I chose were

  1. Trading Forex
  2. Currency futures using CFDs
  3. Spreadbetting currency futures

Some may ask why I wont spreadbet the daily exchange rates directly, well this is because there are rolling daily charges involved which make it much cheaper to spreadbet the futures when hedging currency long term. If you don’t believe me, feel free to try it yourself.

What I will hedge

I want this article to be informative to both small and larger investors, hence I am going to use a small hypothetical sum of $10,000 and hedge against movements in the GBP/USD rate. Now don’t get confused with this, GBP/USD is not a mathematical notation i.e. it isn’t GBP per USD, it’s actually the other way round, USD per GBP (just to confuse us mathematicians!).

I will put charges in terms of percentages so you can see how they vary if that sum is increased to say $100,000, or even reduced to a meager $1,000.

Starting sum: $10,000
GBP/USD spot rate today: 1.52438
Starting sums value: £6,560

1. The Forex trade

For this trade I opened a demo trading account with a European broker. They charge $10 to open and close the position. There are brokers that do not charge any commission but I’m familiar with this brokers platform; I’m going to separate the fixed costs out from the other charges.

The direction of the trade is important to get right (obviously!) but it can get a bit confusing. My £6,560 is in dollars and I want to hedge against that decreasing in value over time, hence I want to hedge against the GBP/USD increasing. (If it increased to say 1.6 my $10,000 is now worth £6,250). So I want to go long GBP/USD so that my hedge makes money if my investment loses money.

The size of position is simple to judge in Forex, as the first currency is the base currency and the ‘units’ are based on this. Here we will want a position size of 6560 units of base currency (some brokers may only allow positions per 1,000 units of base currency).

The trade: GBP/USD long 6560 units
Margin required: £32.80 (scales with amount hedged)
Initial Fees: Bid/Ask spread (varies, averages $0.001) plus $20 fixed broker fees including exit (not usual for a broker to charge this).

2. Futures trade

The futures trade is fairly straightforward. A futures contract is an agreement to exchange currencies at a fixed exchange rate at a future date. Currently the contract is to September, which means that the exchange is due to take place on 11th September. Now I don’t actually intend to exchange money, and because I am using CFD’s which mimic future performance I don’t need to worry about settling futures before the expiry date.

Also CFD’s mean I am not restricted to numbers of contracts, and can just hedge against any dollar amount I wish. Again for this trade I’m going long GBP/USD which means I need to go long the future.

The trade: GBP/USD September CFD long $10,000
Margin required: £32.80 (scales with amount hedged)
Initial Fees: Bid/Ask spread $0.0003, exchange rate is $0.0005 lower than today’s spot rate = £3.45 total on $10,000 (0.05%)

3. Spreadbetting

Finally, this is probably the most complicated hedge. That’s because spreadbetting pays out based on the difference between exchange rates (buy and sell price) in a linear fashion, whereas I will lose money in a non-linear fashion (I lose more from an increase from 1.53 to 1.63 than an increase from 1.63 to 1.73). To get a rough estimate of how much I need to make per ‘pip‘ (the 4th decimal point of the exchange rate) I need to work out the loss from a hypothetical change in exchange rate.

Long term I would want to hedge against an increase to say 1.80. This would result in me losing £1,000 on my initial investment (now you can see why I’m considering hedging!). Per pip (# pips is 18000.0 – 15243.8) this is a loss of 36p. Most spreadbetting providers have a minimum of £1 per pip but there are a few that do 10p per pip. It does mean that using this to hedge smaller sums isn’t always possible however.

The trade: GBP/USD September long 36p per pip
Margin required: £160 (scales with size of bet)
Initial Fees: Bid/Ask spread $0.0011 (11 pips) = £3.96 (0.06%)

Next time…

The trades are now placed and most of the demo accounts I have opened for this last 2 weeks, but I want to leave this running as long as possible. I know spreadbetters have a habit of randomly closing positions and I want to see if there’s a risk of that here. Also as we have September contracts these should theoretically perform better in the short term but as they move closer to September will give a more accurate picture of the true performance of the hedge.

As you may have noticed, all these trades require margin, you are in effect loaning money to put these on and as such, there are ongoing fees to keeping them open. That is the main thing I want to assess in this series, as well as how well each of these instruments hedges the $10,000.

CLICK HERE FOR PART 3

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Investing Sidekick

Founder of Investing Sidekick. Works as a research analyst and is an avid value investor, always searching for undervalued shares. An SA certified writer.

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