Hi, my base currency is USD and I want to buy a stock that is denominated in GBP (and also the company's revenues are in GBP). Considering that I plan to hold this position for a while what are the best ways to hedge my position through options against changes in the GBP/USD exchange rate? I just want to purely hedge my exposure and not to speculate on the GBP/USD exchange rate. Also, I prefer that the hedge will be relatively cheap and therefore I can tolerate reasonable fluctuations of the exchange rates as long as I am not exposed to substantial changes. Thanks in advance for any response.
Hedge based on delta. However, why are you hedging a linear instrument with a nonlinear one? Why a don't you just sell some GBP?
Because I plan to hold the stock for a while and I can't just sell GBP. If I do that then I will increase my risk, not reduce it -- I will be both long the stock and short GBP, and if the stock goes down substantially and the GBP goes up substantially I will be exposed to two different risks instead of just one. It is different than a situation in which I have GBP in cash that I plan to convert to USD sometime in the future. In such situation, sure, selling futures or forward seems to be a great hedge. But here, as I said, my GBP exposure is due to stock ownership, not due to GBP in cash. Any other ideas?
You will not be short GBP on net. You are long GBP through your stock purchase. You will also be short GBP through the spot fx trade. Net net nothing. Your exposure is therefore to the stock, only, which is one risk, and the risk which you are actively seeking.
And if the stock goes to 0 and the GBP/USD goes to 2.2, will I not have more risk as opposed to a situation in which I just hold the stock? Also, why not just buying out of the money put on the GBP/USD futures or XDB? Or finance this put by selling out of the money call and creating a collar that will narrow the spectrum of the exchange rates to which I will be exposed? I know it will not be a perfect hedge but I don't search for a perfect hedge. I search for a hedge against substantial changes in the GBP/USD exchange rate.
Yes buying the collar on fx futures options would be one reasonable hedge for a natural long GBP position (so why did you ask?). But to get a good answer you need to specify 2 things: 1. Really you need to specify your account structure - when you purchased the stock did the broker/member automatically do the conversion selling your USD base and purchasing the necessary GBP before entering you into the stock trade. I only mention this because i know that IB would basically create a line of credit in GBP and wait for you to manually offset it - without offsetting it your FX risk would be covered and you would pay the financing cost instead. 2. Also for your hedge to be adequate you obviously need to take account of the gbp amount. For example if the $-equivalent value of the stock is less than $62,500* then the cme fx products wouldn't be appropriate you're only option is a cash fx hedge (sell the same amount of £ you had to pay for the stock), i don't like the look of the other listed etf fx options. For the kind of long term hedge you are talking about forget about the delta profile of the options hedge. *I might be wrong, please correct.
Why worry about FX risk ... when you are prepared to invest in a single stock name, which as you point out could go to dust .... unless you are onto a sure fire winner? If you do hedge the FX exposure ... and the stock goes to dust ... then you have no underlying exposure BUT still have FX risk ... which you were trying to hedge away! However you hedge the FX risk, futures or options, you will still be exposed to mark to market p/l and margin calls if it moves against you. What stock are you thinking of? Cheers James