The adjustment there refers to the way that, say if your stock pays a dividend (in gbp) then you will have to adjust the hedge to include that as well if your position is substantial. Or more accurately, as the value of the stock fluctuates then the amount of gbp to be hedged will change. But these are considerations if you have a very large position or you are a perfectionist, in any other case such actions won't justify the transactions costs. FX risk vs stock risk: OK so let's forget the IB account structure, pretend its another broker, and say you bought stock with a value of £10,000, and your account is denominated in USD. You are a natural long of GBP/USD. So your USD account balance will go up if the usd value of the stock goes up. That is either through the stock price rising, or the GBP/USD rate rising (with a £10k stock value in a usd account that will mean you gain/lose $1 for every pip). A standard hedge would be to sell £10,000 GBP/USD at the same time as you buy the stock. Any p&l on this position will simply offset the FX risk on your stock trade. I would like to show the payoffs in a grid but i don't know how to do that. Scenario 1> Stock flat; GBP/USD rises: The usd value of your stock rises. This is offset by your FX hedge which shows an equal and opposite $move. Scenario 2> Stock rises; GBP/USD flat: The FX risk does nothing, the USD value of the stock rises - your account value rises. Scenario 3> Stock falls; GBP/USD rises: The FX risk is still eliminated. The rise in GBP/USD will have a positive effect on the USD value of your stock, which will be offset exactly by the hedge. The stock value will fall, your account balance will fall, and it will be your own fault not the fault of fx. On this short FX position i suspect you will have to pay a financing charge if you hold it for a long time, since you are borrowing gbp whichever way you look at it.
Following my previous comment, here is an example: I take USD100 and convert it to GBP at exchange rate of 1.53, so that I have GBP65.3 with which I buy a stock, and I also sell GBP/USD futures (for simplicity let's assume that the futures size covers exactly the GBP amount with which I bought the stock). The stock then falls by 50% to GBP32.6 and the exchange rate goes up to 2.2. If my FX risk was really covered then my position in USD terms should also fall by about 50% to USD50 (compared to the initial USD100). But in this case my position value will be USD28.1, which is a loss of almost 72% (The stock will be worth 32.6*2.2 and the loss on the futures will be 65.3*0.67 (which is the difference between the rate at which I sold the futures and the new exchange rate)). So I don't understand how my FX risk is covered in such situation. In fact, it seems that the hedge only adds extra leverage to my position, since instead of a loss of 50% (which is the true equity risk here) I will suffer a loss of 72% on my entire position. If you think that I misunderstand something please let me know. Thanks.
Yes that's correct. For such a substantial move there will be overkill from the fact that your hedge will become increasingly too big. For example at the point when the stock value is £50, then your £65.3 hedge is too big, you would need to buy back £15.3. It is an even worse hedge when the stock value is £40 etc.... These are the adjustments i was talking about. So over a long period, maybe you would want to rebalance the hedge at the end of every month. I think there are tools which you can sue that rebalance it in quite high frequency,but for a stock which might gap from 65.3 to 32.6 without trading inbetween there is no way to do it.
Let's assume that such gap risk is there and also that I want to buy the stock for the long-term and cannot adjust and monitor the hedge constantly (also it may be argued that these "adjustments" are actually closing the hedge at a loss, so it will not prevent a loss on the hedged position). In such situation, it seems that the only hedge that will completely eliminate the FX risk is not by using options or futures but by loaning money in GBP and invest this money in the stock (such as the solution that is offerred by IB), isn't it? If this is correct, I am surprised that all of the sophisticated financial instruments (such as options and futures) cannot completely eliminate the FX risk in such common situation and the only way to completely eliminate it is just by loaning money in GBP...
No the IB loan is equivalent to being short GBP/USD, sorry i meant to mention this in the previous post as well. But you still have the problem of having to adjust the size of the credit/loan. The only reason IB operates like this is because its the easiest way to deal in many products across the world in a universal account. Most IB customers do it all the time without realising they are building up fx balances all the time. Right so, when you buy the gbp stock through IB, and you have no pre-existing gbp balances, then in order to buy thatstock they lend you the £65.3 and use your usd as collateral. As described earlier this takes away some of the fx risk because a loan is a liability and is like being short something (just like having a mortgage is like being short the real value (less inflation) of money). However, just like your example it will need to be adjusted from the £65.3 at the start, just like in our example you would need to adjust your £63.5 hedge. If this is correct, I am surprised that all of the sophisticated financial instruments (such as options and futures) cannot completely eliminate the FX risk in such common situation and the only way to completely eliminate it is just by loaning money in GBP... [/QUOTE] The real problem is not the FX hedging solutions, it is the equity. In fixed income and money markets you know the future value of your investment upon maturity, so you can hedge that exactly. With equity you have no idea how much it will be worth in the future, so you don't know how much foreign currency you will need to hedge, hence the need for adjustments. You could invest in ADRs, and give someone else the job of adjusting for the exchange rate. To be honest i think fx derivatives have been pretty successful in eliminating risk. I don't think this case (50% gaps) is entirely representative. Anyway i hope that makes it a bit clearer.
Thanks again for your willingness to assist. Much appreciated. I'm sorry but I don't understand why the IB loan is equivalent to being short GBP/USD. In the example that I gave, if I have $100 as collateral and I buy stock at £65.3 by using a loan (so that the $ covers the full £ amount at 1.53 rate), then even if the stock goes down by 50% to £32.6 my real loss would be 50%, which is exactly the equity risk and therefore the FX risk was completely hedged. True, I may have to add some usd collateral but in the bottom line, if I close the position by selling the stock at £32.6 then my realized loss on the entire position is 50%, and not 72% as with the futures. Am I wrong?
Yeah. Do it on a piece of paper. What has happend is that you have fx risk to your pnl. So as the stock moves you need to adjust your fx risk. If one position is static then you are right that you have "dollarized" your GBP stock. The formula is something like (change FX) + (change Stock) + (change FX)*(change Stock).
No problemo. The loan case is really IB specific, so take a look at some of their materials on their site, look for "mechanics of an overseas trade" or something similar sounding. I think you might have been confused about my description of the loan since it was poor. You have the futures case correct, but not the loan case. The loaned amount stays the same in £terms, but fluctuates in usd terms - hence your account balance will change. Think of your account in terms of assets and liabilities: You have an account in USD. The exchange rate is 1.53. No financing charges or transactions costs, ignore the collateral requirements. You buy the foreign stock for £65.3, the £ to purchase this with is loaned from IB. Now at this point your account equity still reads $100 -why? because nothing has changed. Your stock (asset) is still valued at £65.3 and the USD value of that =$100, which is the same as your liability which is also valued at (£65.3/$100). Hence there is no change. Vale. Next, the stock falls to £32.6 and the new exchange rate is 2.2. What is the value of your assets? - the stock is £32.6 at the new exchange rate that is $71.72 What are your liabilities? - You borrowed £65.3 from them, now that is equal to $143.66 which is the dollars required to pay down the loan. The difference 71.72-143.66 will be the change in your USD account equity = -$71.94, giving an account balance of $28.06 the same as in the other case where you hedge with the futures. This is because like in the other case the size of the hedge (or in this case the loan) doesn't adjust automatically to the value of your assets.
Great explanation. Now I understand. Is the futures alternative preferable to the IB's loan since there are not financing costs involved? Or the financing costs will anyway be refletced in the futures price so these two alternatives are basically identical?
Yeah the futures are probably less costly than financing it through IB. I would say what you lose is the divisibility that you get when you trade the cash (as in the IB loan scenario), for example when you re-adjust your hedge you will have to do it in increments of£6,250 which is the contract value of the e-micro gbp futures on cme, i would do it that way. If your account was quite tight on margin you might also want to check out which is more: the collateral required to be held against the IB loan vs the margin requirements for the futures. Good luck!