Hi to all. I have a question regarding forex hedging: If I want to effectively hedge an amount that is to be converted from USD to EUR, so that I just want to "fix" the current EUR/USD conversion rate in a way that will enable me to convert the amount back to USD within one year at the same rate that I originally converted it to EUR, on which hedging strategy would you recommend? I considered using FX futures but the problem is that if I sell EUR/USD futures and the conversion rate goes up I will be in a big trouble. Also, using FX futures options seems problematic since the one-year options are not so liquid and the premiums are pretty high, so the strategy is costly (and also the short-term futures options don't seem attractive in this respect). But I am sure that with the plenty of financial instruments that are existed today there must be an effective and cheap way to make the simple hedge that I want and that you guys can help me. Thanks a lot!
Can you be more specific? I am trying only to make a pure hedge, and using leverage may introduce additional and unwanted risk, isn't it?
Example: Investors or traders protect the value of their funds by keeping them in CHF. Investing or trading these funds in USD runs the risk of currency loss - about 25% in the past 12 months. Most simple way to protect the funds in such a case is to sell USDCHF in the forex cash market. If you had done this one year ago, your funds would be about 35% more today. This is the most simple form of hedge against currency losses I know of. Felix
Do you mean actually selling my USD and buying CHF in cash instead? If so, the problem is that I want to trades equity options with other currencies than CHF. So even if the CHF is stronger than the USD as a currency, I prefer to have my USD as the basis currency and when I want to trade options in EUR I want to be able to convert the EUR back to USD at the same rate, so that I will not be exposed to forex conversion rates risks. What about hedging with futures, such as selling the CME traded EUR/USD contract simultaneously when I originally convert my USD to EUR? To what risks am I exposed in such a hedge?
The best option would be a FX forward contract, set at a delivery date one year from now. You'd have to look around a bit for a dealer who will deal with forwards for a retail trader (they do this all the time for institutions). I know Saxo Bank does forwards, but I've also seen some really poor reviews. You can also hedge with spot FX, but then you assume interest rate risk (the positive/negative difference between interest rates of EUR and USD will fluctuate during the next year.) Buying a futures contract is also an option, and you assume the interest rate risk every time you roll to the next contract month. You also have to buy a minimum of $100,000 per contract. Liquidity will be pretty good, though.
Thanks for the response. Could you please elaborate on spot FX? I am not so familiar with FX instrument, I apologize in advance. You mentioned the effect or interest rates and I wonder if there is any hedging instrument that will enable me to transfer a currency which its interest rates are zero (USD) to a currency which its interest rates are higher (EUR) or even much higher (AUD) while being fully hedged against any change in the conversion rate and while still being able to enjoy the interest rate spread? I assume that probably the interest rate difference will be priced into every hedging instrument that is existed (whether it is forward, futures, spot FX, etc.) so that there are no "free lunches" in this regard. However, just in case there is such hedging instrument that enables what I described please let me know
Spot FX is what most retail traders trade. It is what you see advertised on all those "trade forex and make big money" ads. You can trade it through dealers like FXCM, Oanda, Dukascopy, Interactive Brokers, etc. (Interactive Brokers also brokers FX futures). It is basically a forward contract that settles every night (although the settlement process is transparent to the trader.) Because you are borrowing in one currency and buying another, the net interest charge either adds or subtracts from your account daily. Unfortunately, there is no "free lunch" in currency hedging. The interest rate difference is priced into all forward contracts, and arbitrageurs with $millions worth of high-speed trading systems keep everything in line. See the link below for how it's done: http://en.wikipedia.org/wiki/Covered_interest_arbitrage The process of shorting a low-interest currency (USD or JPY) and buying a high(er) rate currency (AUD or NZD) is called "uncovered interest arbitrage" or "carry trade", but exposes you to currency fluctuation. So, you need to evaluate what kind of risk you want to take. If you really want to be sure and "lock in" a rate, buy a 12-month forward contract. Every other option requires you to take some sort of other kind of financial risk.
Thanks for the explanation. In your previous response you made a distinction between FX forwards (through dealers) and Spot FX. Are both of them forward contracts and how do they differ from each other?
Both spot FX and forwards are traded through a dealer. Trading with a dealer literally means TRADING with it - he takes the other side of your trade. Spot FX resets every day, while a forward rate is guaranteed for the term of the contract. FX futures are standardized contracts trade that through an exchange via a futures broker (EuroUSD Fx trades through the Chicago Mercantile Exchange.) The broker/exchange only acts as a middleman - you trade with another person. Futures are like forwards - you have to "settle up" at the end of the term, but have standardized contract sizes and terms (Euro futures trade in $125,000 contracts and expire a few times per year.) So, forward contracts give you more flexibility with size and term, but there are fewer dealers out there that can do them, while it is generally easier to trade futures (at least during market hours), but you are limited to their specific terms and sizes. FX spot has plenty of dealers that would be willing to do business with you, but spot is used more for speculation than hedging.