Exchange Rate Risk & Hedging Techniques - 1 | UGC NET Commerce Preparation Course PDF Download

• Understanding Exchange Rate Risk

• Exchange rate risk, also known as foreign exchange (forex) risk, is an inherent peril associated with investing in foreign markets. This risk stems from the fluctuations in the value of your local currency compared to the currency of the foreign investment.
• For instance, if you are a U.S. investor looking to invest in European stocks, changes in the EUR/USD exchange rate can impact the returns on your investment when converted back into U.S. dollars.

• Managing Exchange Rate Risk

• While it's impossible to completely eliminate exchange rate risk, there are strategies to significantly reduce its impact through hedging techniques.
• One common method is to use currency forwards or futures. These financial instruments allow investors to lock in an exchange rate for a future date, thus protecting themselves from adverse currency movements.
• For example, a U.S. company that expects to receive payment in euros in six months may enter into a currency forward contract to hedge against potential losses due to a weakening euro.

• Utilizing Hedged Investments

• Investors can also opt for hedged exchange-traded funds (ETFs) that are specifically designed to mitigate exchange rate risk.
• These funds typically use derivatives such as forwards or options to offset the impact of currency fluctuations on the underlying assets.
• For instance, an investor interested in Japanese stocks but wary of yen fluctuations could consider a yen-hedged ETF to safeguard their returns against adverse currency movements.

• Conclusion

• Exchange rate risk is a crucial consideration for international investors, but it doesn't have to be a barrier to diversifying portfolios globally.
• By understanding the nature of exchange rate risk and employing appropriate hedging strategies, investors can navigate the complexities of foreign markets more effectively and protect their investments from currency volatility.

Understanding Exchange Rate Risk

• Significance of Hedging Exchange Rate Risk

  For investors, managing exchange rate risk is crucial to protect returns on international investments. When the U.S. dollar strengthens, U.S. investors should hedge to prevent erosion of returns from overseas investments. Conversely, foreign investors benefit when their local currency weakens against the USD, boosting returns on U.S. investments.

• Optimal Hedging Strategies

  It is advisable to leave exchange rate risk unhedged when the local currency is depreciating against the foreign-investment currency. On the other hand, it is prudent to hedge this risk when the local currency is appreciating against the foreign-investment currency.

• Ways to Mitigate Forex Risk

  • 1. Natural Hedging

    One approach to mitigate forex risk is through natural hedging. For example, a U.S. company with operations in Europe may receive revenue in euros, naturally offsetting currency fluctuations.

  • 2. Financial Hedging

    Financial instruments such as forward contracts or options can be utilized to hedge against exchange rate risk. For instance, a company can use forward contracts to lock in a future exchange rate for a currency transaction, reducing uncertainty.

• Investing in Hedged Assets
  • One effective strategy is to invest in hedged overseas assets, like hedged exchange-traded funds (ETFs). These ETFs are widely available for various underlying assets traded in major markets.
  • Many ETF providers offer both hedged and unhedged versions of their funds, which track popular investment benchmarks or indexes. While the hedged fund typically has a slightly higher expense ratio due to hedging costs, large ETFs can hedge currency risk more cost-effectively than individual investors.
  • For instance, consider the MSCI EAFE index, a key benchmark for U.S. investors measuring international equity performance. The iShares MSCI EAFE ETF (EFA) has an expense ratio of 0.32%, while the iShares Currency Hedged MSCI EAFE ETF (HEFA) has an expense ratio of 0.70.
• Hedging Exchange Rate Risk Independently
  • Investors often have exposure to foreign exchange (forex) if their portfolio includes foreign-currency stocks, bonds, or American depositary receipts (ADRs).
  • A common misperception is that their currency risk is automatically hedged, which is not the case. It's essential for investors to actively manage and hedge their exchange rate risk.

Special Considerations

• Currency Risk Hedging
• Introduction: Hedging currency risk involves using various financial instruments to mitigate the impact of exchange rate fluctuations.
• Options Available: Companies can employ different instruments to hedge against currency risk.
• Forwards: These contracts allow entities to lock in an exchange rate for a future date. For example, a company in the US expecting payment in Euros in six months might enter into a forward contract to fix the exchange rate now.
• Options: Companies can also use currency options to protect against unfavorable exchange rate movements while still being able to benefit from favorable ones. For instance, a firm can purchase a call option to buy a set amount of foreign currency at a predetermined price.
• Futures: Futures contracts are similar to forwards but are standardized and traded on exchanges. They provide a way to hedge against currency risk through a regulated platform.
• Currency Swaps: In a currency swap, two parties exchange principal and interest in different currencies for a specified period. This helps manage currency exposure effectively.

• Currency Risk Hedging Techniques
  • Currency Forwards
    Currency forwards serve as a valuable tool for hedging currency risk. Consider a scenario where a U.S. investor holds a euro-denominated bond set to mature in a year. To shield against potential euro depreciation relative to the U.S. dollar, the investor can engage in a forward contract. This contract involves selling euros equal to the bond's maturity value and buying U.S. dollars at the one-year forward rate. While forward contracts offer customization benefits, they are typically inaccessible to individual investors. An alternative approach involves constructing a synthetic forward contract through a money market hedge.
  • Currency Futures
    Currency futures are employed to mitigate exchange rate risk due to their exchange-trading nature and requirement of minimal upfront margin. However, these futures lack customization features and are limited to fixed dates.
  • Currency ETFs
    Currency exchange-traded funds (ETFs) utilize specific currencies as underlying assets to hedge against exchange rate risk. While not the most effective method for large amounts, they offer advantages for individual investors by allowing trade in small amounts, being margin-eligible, and supporting long or short positions.
  • Currency Options
    Currency options present another viable strategy for hedging exchange rate risk. These options grant investors the right to buy or sell a particular currency in a set amount on or before the expiration date at the strike price. For instance, Nasdaq-traded currency options are available in denominations suited for individual investors.
• Exchange Rate Risk Mitigation

  While complete avoidance of exchange rate risk in overseas investments is challenging, it can be significantly reduced through various hedging techniques. One straightforward method involves investing in hedged instruments like hedged ETFs.

• Importance of Hedging Exchange Rate Risk

  • Cost-effective Forex Risk Management

    The fund manager of a hedged ETF can effectively hedge forex risk at a lower cost.

  • Diversified Investment Protection

    Investors holding foreign-currency stocks, bonds, or ADRs should consider hedging exchange rate risk using various tools like currency forwards, futures, ETFs, or options.

• iShares MSCI EAFE ETF

  • iShares offer the "iShares MSCI EAFE ETF" for investors interested in international equity exposure.

• iShares Currency Hedged MSCI EAFE ETF

  • The "iShares Currency Hedged MSCI EAFE ETF" provided by iShares helps mitigate currency risk for investors.

• FX Options Product Specifications

  • NasdaqTrader.com offers comprehensive details on FX Options Product Specifications for investors looking to participate in the foreign exchange market.

• Options Trading Concepts

  • Fraption, an options trading term, remains essential in understanding and executing options strategies.

  • Exploration of concepts like Bull Put Spread, Credit Default Swap Index (CDX), Exercise Price, Forward Rate, and Put enhances investors' knowledge in options trading.