How to use FXE to hedge EUR.USD currency risk

Discussion in 'ETFs' started by Joan, Nov 10, 2017.

  1. Joan


    Hi everyone!

    I'm investigating how I could hedge the EUR.USD exchange risk using the FXE etf.

    I'm european and I live in a EUR based country.
    I open a trading account funded with 25000 EUR.
    I want to trade US stocks, so I convert, let' say, 20000 EUR to 23306 USD. Rate 1EUR = 1.17 USD
    I want to keep some long US Stocks positions for some years.
    After some years I will convert back the USD to EUR, at 1EUR = ?.?? USD

    How can I use the FXE to lock in the EUR.USD exchange rate so it doesn't affect my returns?
    Thank you guys!
  2. quant1


    Since FXE is an ETF, it has a NAV (net asset value) and some index risk. The general rule is that the NAV at day t, NAV(t), is related to the NAV(t-1) via the following formula:

    NAV(t) = (1-f)(1+R(t))NAV(t-1)

    Where f is the daily expense ratio and R(t) is the return of the ETFs index for that day. Looking at FXEs prospectus, we can see that the expense ratio is .40% nominal annual so f=.40/365, R(t)=daily euro return.

    To hedge Euro risk, you will need to buy the same notional amount of FXE as your transaction in Euro. For example, if the current price of SPY=$100, Euro=$1.1000, and FXE=$10, and you want to buy 1 share of SPY, you will:

    1. Buy 1 share of SPY for 100/1.1000=90.90 euros

    2. Since you are effectively short 90.90 euros, you can buy 90.90/10=9.9 shares of FXE to hedge

    Keep in mind you will pay the expense ratio daily so you won't be perfectly hedged.
  3. Sig


    And although academic when discussing EUR/USD the interest differential between the two currencies is also either credited or debited to the ETF.
    quant1 likes this.
  4. Joan


    Thank you guys quan1 and Sig, for your answers.
    Some questions that arise:

    Before buying the 1 share of SPY for 100$. I will convert 90.90€ to 100$.
    Should I not hedge these 100$? Should I not hedge 100$/10$ (1 FXE share = 10$) = 10 FXE shares? I don't understand why you divide the 90.90 euro amount by the 10$ FXE price share, they are different currencies!

    Another question that comes to my mind is what happens to the USD dollars that I need to buy the FXE shares? Those USD dollars are not hedged again, correct? Have in mind that I'm european and I want to convert back to EUR at some point in the future, not they other way.
  5. Two different operations must be taken into account:
    1/ Convert EUR in USD
    Buy USD asset (USD cash is now 0)
    2/ Hedge your forward risk in USD.EUR

    With your example:
    1/ Sell EUR 20000 to USD 23400 (1 EUR = 1.1700 USD) (conversion)
    Buy 90 SPY @ USD 260
    2/ Buy 0.1872 EUR Dec18 2017 future (0.1872 = 23400 /125000 where 125000 is the notional future)
    Roll the future

    By assuming the delta of future with spot is 100%
    Buy 20K EUR/USD (1 EUR = 1.1700 USD) and adjust according to SPY variation

    Indeed, the use of FXE implies the purchase of USD asset: complexity arises.
  6. Joan


    Thanks @betcashrun

    Using futures is another option that I am thinking about too. But I didn't fully understand you.
    Is it possible to buy a 0.1872 fraction of a future contract? There is the micro contract 12500 EUR, but still having to hedge in multiples of 12500 is not convenient.

    I did not understand this part:
    ...By assuming the delta of future with spot is 100%
    Buy 20K EUR/USD (1 EUR = 1.1700 USD) and adjust according to SPY variation...

    Could you clarify what it means, please?
  7. It is not possible to buy a fraction of a future. Instead, the hedging instrument is the spot.
    In Hull 'Options, Futures and Other Derivatives', one can read: F = S exp((r-rf)T)
    Where F is the FX forward, S is the spot, rf is the foreign risk-free rate
    Hence dF / dS = exp((r-rf)T) which is close to 1
    Buy 20K EUR/USD is not a conversion but a trade on currencies. It means USD23400 are borrowed to buy EUR20000. One pays USD interests and receives EUR interests daily.

    On a side note, if a broker allows FX trading, it usually means one can directly buy foreign asset and the FX swap is automatically put in place. To be clear, in that case absolutely nothing special with FX is needed.

    However, the residual FX risk is linked to the P&L:
    Assuming SPY jumps 50% overnight, the USD exposure is now USD11700.
    Assuming SPY crashes 10%, the USD exposure is USD -2340.
    So one needs to define a limit above/below which additional FX hedging is required.
  8. Joan


    Sorry, but I'm not sure if I'm following you.
    I have a margin account with IB. My base currency is EUR. I have cash in EUR in my portfolio. When I buy some stocks in USD, a negative cash balance is created in USD. I supose that's the automatic FX swap, correct? I then have to pay 2.66% interest of the negative USD balance.

    Is there a better way of hedging my USD stocks without paying the interest rate in IB?
  9. H2O


    In your situation, IB is providing you with a margin loan in USD on which you pay interest. The OP is taking a different approach: He does not hold a EUR balance but converts all his EUR into USD. When he now buys US stocks he will use his USD balance and therefore he does not pay any interest (providing he does not use margin). The conversion of his EUR account balance into USD means however that the OP's account is now subject to FX fluctuations.
    In order to eliminate / reduce this risk, the OP can purchase a EURUSD future (or any other instrument that tracks EURUSD). As long as the costs of running such position are lower than the interest paid on a negative USD balance, this works out cheaper than what you are doing now.

    I hope this is clear
  10. Joan


    thanks @H2O
    I'm the OP. I trying to figure out what instruments could be bought that track EURUSD without increasing USD currency risk even more, without having to convert more EUR to USD.
    For example, looks like to me that (please, anybody correct me if I'm wrong):
    1. FXE etf, is not suitable for a EUR based investor because to buy it you have to buy shares in USD. So you could hedge some part of your other USD stocks but not the dollars used to buy the FXE shares.
    2. Buy EURUSD futures. It is possible to keep your futures margin in EUR so this could work. Problem is smallest contract is 12500 EUR. So any amount in between multiples of 12500 EUR converted to USD will not be fully hedged.
    3. Buy FX pair EURUSD. this looks equivalent to the margin loan provided by IB. Buying the FX EURUSD will create a negative USD cash balance that I will have to pay the 2.66% interest.
    4. Ideally, there should be some instrument denominated in EUR that tracks the EURUSD pair. This would avoid the margin loan interest from IB and would also avoid having to convert more EUR to USD and so avoid increasing the currency risk.
    Any ideas?
    #10     Nov 22, 2017