Currency hedging

Investing / Portfolios
102

I think hedged vs unhedged is very complicated problem. You would find evidence for either case.

My conclusion is that whatever the investor decide (hedged or unhedged), they need to stick to it for very long term

And then expected return hopefully would be same minus costs (hedging costs , TER) . But there is no conclusive evidence

JPY lost significantly its value over the last few years against all major currencies. So hedged version would have performed better

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103

No he means the trade itself.

Meaning going short JPY and going long another strong currency. Normally you‘d do this with high interest currencies. It just happens that the CHF is strong and appreciates rather than paying interest.

And you are effectively doing that trade when currency hedging your Japan exposure.

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104

No, I don’t mean the crash last month, but a steady depreciation of JPY vs. CHF last what, 10 years?

The problem with hedged equity that I see is that there is an equity investment overlayed with FX options. While I may believe that hedged equity can have a lower volatility than the unhedged one, I don’t believe that you can have higher long-term returns with hedging. Hedging is an insurance. You don’t earn with insurance, you pay for it.

By themselves, short term FX fluctuations vs. the expected long-term trend can go in either direction. Most probably this time it was pure luck that JPY systematically depreciated against CHF more than it was expected. I don’t see a point in making any kind of theory out of this.

I would be glad to be corrected, as always, but until I am convinced in something, I am happy to use the efficient market razor and stick with what is known to work.

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105

If futures are used, it can’t be paid insurance for both sides of the trade if there is no spread. But if both sides are hedgers, one side has to win if the other pays.

In a closed system the total return must be 0, but we don’t have a closed system:

  • on a first level, every day investors enter and exit subsections of the market, some of them leaving losses or taking gains from it
  • on a second level, outside factors like taxes, fees, or inflation, demand influence the value of your assets
  • on a base level, production minus consumption is different from 0

There can even be improved return for both sides in absolute terms (given they find anti-/un-correlated assets). Let’s have a look how “hedging” part of your portfolio with uncorrelated pairs can improve returns. We will go one full circle with asset values and exchange rates ending where they started, but our total value having increased.

Stocks move CHF/USD move Stocks price [CHF] CHF/USD rate [USD] Unhedged [CHF] Hedged [CHF] Total [CHF]
Start 100.0000 1.1500 50.0000 50.0000 100.0000
Market moves 1.0100 0.9990 101.0000 1.1489 50.5000 50.4565 100.9565
Rebalance 101.0000 1.1489 50.4783 50.4783 100.9565
Market moves 0.9901 1.0010 100.0000 1.1500 49.9785 50.0224 100.0008
Rebalance 100.0000 1.1500 50.0004 50.0004 100.0008

How rebalancing works should be clear. The unhedged position just moves with the market. The hedged positon is a bit more complicated:

hedged\ *\ (stock\_move\ +\ (rate\_move\ -1)/rate)

Basically the position moves by whatever stocks move. But we have an additionally big notional position in CHF/USD futures. This gives us the difference of whatever the rate moves in USD. Since we calculate in CHF, we still need to divide this return by the rate.

Some remarks:

  • Numbers are rounded.
  • I used anti-correlation, rates move the opposite of stocks. The returns will be negative if the correlation gets high. Even just a correlation of 0, will give a slight negative return.
  • If the volatility of our futures contract is much higher than the stocks, return is also negative.
  • I assumed no difference in interest rates. But as the expected total return on the futures contract, even with such a difference, is still 0, it shouldn’t matter much.
  • This is basically arbitraging anti-/un-correlated volatility. This has nothing to do with stocks or currencies.
  • Trading friction would probably eat the meager return and then some.
  • This is just mathematics, one could probably derive multidimensional graphs, splitting the vector space in areas with positive and negative return. Once it’s shape is understood intuitively, qualitative answers about where there is a rebalance premium, and where there are pitfalls, could be given with more confidence.
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106

What about currency hedging in other context than stock/ETF investments ?

Most of my wealth is long-term into my business which has a big, unavoidable USD cash position (like it’s about 70% of my net-worth). USD/CHF exchange rate is very volatile and I am feeling less and less comfortable with such a big USD exposure as a Swiss resident.

I’d like to hedge at least a part of it. What are the best tools for the job ? Margin borrows ? Forex futures ? Options ?

In terms of costs, I’m aware that I probably will have to pay at least the USD-CHF interest rate differential (Already 4% atm :skull:).

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107

Have a look at the article at this link UBS

It explains common approaches for SMEs. This can help to understand concepts. To actually execute , you would either need to use your brokerage account and do it yourself or use one of the structured products offered by Swiss banks.

If you choose to use structured products, I would suggest to shop around a bit because you might get better conditions.

@tokzoo if you are interested in how Forex Forwards work, have a look at this video Link

I have never done it myself but for you it might be useful as you have business operations

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108

There are many things that could be done about this cash position. But that very much depends on the reason for this. Could you be less mysterious and explain:

  • why this business needs so much cash that cash becomes 70% of your net-worth? What would happen if it was less?
  • I assume your business has some return on the capital invested. Did you take its value for net-worth calculation directly from the book?
  • What is the remaining 30%?

Depending on your answers hedging could even be a very bad idea.

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109

Thanks, you actually made me realise that it is a common problem for any business with client/suppliers abroad. So it’s probably worth reaching out to some experts.

Sure, it’s basically the collateral for some niche trading business (algo trading). It needs to be in USD, I cannot directly use CHF collateral. The returns are quite high and more than justify the opportunity cost of other regular investments. You could maybe argue that the best is simply to not bother with hedging since the high returns would make up for FX losses long term. But still, the long term outlook for USD/CHF is down only. I regularly have great PnL month in USD but then big losses in CHF terms (e.g: USD is down 5-6% since late july…)

The remaining 30% of my wealth is mostly regular equity ETF.

110

Yes. I saw once a study that 40% of businesses in Switzerland hedge their exposure . Link here

Good luck.

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111

So it is a flexible liquid 70% (i.e. you could stop it fully or partially and get everything out without reductions at any time).

You say it is collateral. Do you actually have a net position in USD? For example, if you hold a notional 100% of the USD collateral in long ES futures (long S&P 500, short USD), you will have no exposure to USD and only to the S&P 500 (plus minus some friction). If you overlay that with an additional S6 futures (long CHF, short USD) your net position will be:

  • +100% S&P 500
  • -100% USD
  • +100% CHF

The attempt at hedging resulted in a (negative) exposure to USD. That is not what you wanted, you wanted no exposure.

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112

Correct, I’d pay some transaction fees and some spread but it’s still minor. The positions are liquid.

My trading strategies are what I call delta neutral (Like I would for example hold a long ES + short ES the same size somewhere else). So my net position at anytime is just 100% USD.

Now, what i’m talking about is hedging at least part of that USD exposure by overlaying some long CHF, short USD position somehow.

113

Do you mean short and long different stocks from the S&P 500 index? Or is this options trading? Arbitrage on ES futures seems to be more an area for high-frequency traders with direct (expensive) access to exchanges.

I assume you have leverage. Could you hold your algorithm at 100% net stocks instead of 100% net USD?

Alternatively, S6 or ES futures could reduce net exposure to USD to 0% in favor of something else (CHF or S&P 500). Futures need a small collateral (<10% of notional). At IBKR that is cash without interest. Every day the futures are marked to market and cash changes hands. Short-term this could come from a margin loan on your 30% ETFs (so you don’t get liquidated and don’t need to hold even more cash ready).

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114

It is basically arbitrage, so long + short of contracts of the same underlying. Obviously, I am not doing this with ES but in some niche Cryptocurrency markets. The goal is not have crypto exposure, so the algo always targets net 100% USD exposure.

I thought about buying S6 futures, but these expire every quarter so I assumed it was for some shorter term hedging.

115

Ah, now it makes sense.

The spreads in highly liquid futures are next to non-existent. Can’t be 0 else there would be a trade. You just roll (sell old contract and buy the new one) before maturity, but since friction is very low, you won’t lose much. The highest volume is normally some days before maturity.

Of course over the whole duration you will continuously lose/gain the expected cost of carry (interest difference for currency futures). If you hold to maturity you get exactly the expectation when you bought (plus price movement). But until that day there is some variance from changing expectations (plus price movement).

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