Playing around with currency exchange rates

Hi,
Long time lurker and beginner here.

Assume I have 20k in VT at ARCA in USD and 20k in VWRL at EBS in CHF (please don‘t ask why).

When CHF gets stronger, I could sell VWRL, convert the money to USD and buy VT. The other way round when CHF gets weaker, I sell VT, buy CHF and VWRL. This would cost a couple of bucks and gains would be around 100-300 bucks.

Let‘s say that I don‘t care if I have the one or the other (VT/VWRL, I know that they are not totally the same).

What are the risks here (if I don‘t care to get stuck with one)? Am I missing something?
Sure maybe the exchange rate won‘t „go back“ and this will stop.

I know that one shouldn‘t time the market, but why does it work sometimes? :slight_smile:

If you want to play the lottery by arbitrating currencies, it’s better to play with covered options and pocket the premiums along the way. I think this option (no pun intended) has a better chance of success, otherwise everyone would be doing currency arbitrage…

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Doesnt work. When the CHF gets stronger, the CHF price of VWRL will reduce accordingly so that VWRL in CHF still equates to VT (in USD) times the CHFUSD FX. Or in other words, you can not gain a single cent but you just incur additional transaction cost.

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Wow, that helped me understand quite some things. Thank you! :slight_smile:

I have one follow up question: This means that the current currency exchange rate doesn’t matter at all when buying an ETF like VT, right? (in terms of purchasing power, not the indirect influence on the companies held) The currency it is bought with means nothing (disregarding fees, stock exchange, volume etc.)?

Yes, see the wiki entry:

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Thank you!

Also great wiki entry - didn’t see it at the time and will take some time to read it.

I have a follow up question: Why is there in the ETF-world so much talk about „currency risk“ and why do hedged world index-ETFs exist?

Example: https://www.justetf.com/en/news/etf/the-effect-of-currencies-on-etfs.html

Exchange rate fluctuations also add to and subtract from the local returns of overseas securities. For example, if US stock market prices dropped 5% while the dollar simultaneously lost 5% against the pound, then a UK investor would see a 10% total loss.

Other example (in German, sorry): https://youtu.be/xU6YEIaO_74
They say somethin like: „When the Euro loses value, so does the stock denominated in EUR“ (which is wrong if arbitrage is possible).

I‘m confused about Bogleheads.org: Currency risk for non-US investors - Bogleheads

you hold foreign assets, your return is the sum of

  • the return of the underlying assets, and
  • any gain or loss in the exchange rate between your home currency and the currency (or currencies) of the foreign assets.

What is the currency of the foreign asset? Does a big index ETF hold a lot of currency? They are not talking about the denomination.

That is, it is the currency of the assets that the ETF holds, not the ETF’s trading or denomination currency, that matters most.

There are many more examples (just google „etf currency risk“).

Also why does this exist? MSCI World 100% Hedged to GBP Index (GBP)

I had a disussion with a friend who was worried about currency risk: He couldn‘t argue against the arbitrage, but for him the exchange rate to the denominated currency looks like a performance loss. That‘s why he sent me lots of examples from the internet.

I think I just understood what most of them are about: It‘s about the exchange rate between the home currency and the index/asset hold.

If the CHF gets stronger compared to the world index (e.g. VWRL or similar), I get back less CHF for the same asset. This explains hedged ETF.

It has nothing to do with an other currency though, right? Why does everyone talk about two currencies?

As the denomination currency doesn’t matter, it also doesn’t matter at which level you look at the denomination. You can look at the denomination of the individual holdings of the ETF, the denomination of your own ETF holdings, or its value stated in your local currency. It is all just a recalculation of the value of the underlying holdings stated in another denomination.

  1. You can hide fees if returns can not be compared anymore.
  2. Hedging a broad basket of foreign currencies to your own consumption could theoretically have benefits.
  3. There could be a favorable (anti-)correlation between exchange rates and the assets you hold. But it could also be unfavorable.
Details about the second point

The reason lies less with the foreign stocks, they move up and down according to their own rules. The reason is that this hedge should only react strongly if it is your own currency that moves.

Maybe suddenly local Swiss bread has double the value because the Swiss Franc doubled in relation to every currency elsewhere. Then it is likely that it is really the Swiss Franc that moved, and other assets (e.g stocks) are not impacted, similarly to the foreign currencies.

This of course only makes sense up to your local consumption affected by the Swiss Franc, only if it is not already covered by local income, and only if you do hold at least a comparable amount of assets that are not correlated.

You can gain a rather safe and simple access to such a hedge by using the holdings of the ETF as collateral.

How often and by how much that will benefit you depends on a myriad of factors, and I don’t have hard numbers.

Corollary: By the same logic one could argue that one should do the opposite hedge for money that will be earned in local currency, but is scheduled for investment instead of consumption.

Wrong, if the USD/CHF rate doesn’t change then the return of a hedged and an unhedged S&P 500 ETF is exactly the same. Edit: Plus minus interest rates of the two currencies, of course.

What you suggested is hedging the stock index to a (/your) currency. This gives you the return of… the currency. That, of course, wouldn’t make sense. It would be simpler and cheaper to just hold the currency instead of stocks.

Because the “asset/local currency”-rate is equivalent to the product of “asset/denomination currency” and “denomination currency/local currency” rates. Only the later two are commonly displayed (else the combination of all possible pairs would flood your screen).

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No, the hedged fund will have paid the price of FX forward contracts (or a similar instrument), which will lower the return of the hedged S&P 500 ETF if the USD/CHF exchange rate remains constant. That’s assuming the relevant USD interest rate is higher than the CHF interest rate, as has been the case for a long time.

You can find the current prices of forward contracts here: USDCHF - U.S. Dollar/Swiss Franc Forex Forward Rates - Barchart.com

Based on interest rate parity, the market assumption is that the USD weakens against the CHF. If the USD weakens exactly as assumed (matching the interest rate difference), then a hedged and unhedged S&P 500 ETF will have the same performance (assuming identical fees and ignoring the spread of forward contracts).

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True, my example is not precise enough. But regardless, it is not connected to the S&P 500.

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Thanks a lot for the elaborate responses. I took some time to chew through it and I think I understand most of it, leaving some remaining questions.

What do you mean with „hedging by using the holdings of the ETF as collateral“?

I think this is the culprit of all my confusion: In the product above you could (mathematically) delete the denomination currency - why show it all? Why not just show „asset/local currency“ (which e.g. IBKR does if whished)? Is it because the asset is denominated in USD to avoid confusion, meaning that someone doesn‘t think they can buy VT in CHF?

Rephrasing the situation: It‘s about the goods that have arbitrage (like the ETFs) and the goods which haven‘t (local goods, cash one is holding), right?

Thanks again for helping me understand all of this. I am an overthinker and really try to understand these things. (Actually rereading your answer right now, I maybe need some extra time thinking about it. :sweat_smile:)

Well, if the hedge moves against you, what assets will pay the other side? As it is the ETF entering that contract (and not you directly), it is also the ETF which needs to pay with its assets. Those assets act as collateral and will be sold to pay the other side (instead of immediately being bankrupt).

Yes, I think that is a good reason. This calculated price of VT in CHF is less real, you can’t trade it directly. To a lesser degree this is also true for the market price, which normally is just the last price it traded at. If you want something more real Bids and Asks are better. But these best offers only have a limited size. More offers are found behind them (at a worse price for you).

Everything is arbitraged, even if it is not directly traded against each other. If you follow any path of quickly trading one thing against another, once you get back to the first asset you should have the same amount (minus fees and spread).

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First of all VWRL and VT are not the same ETf because they have different underlying investments. As you already pointed this out, I think you know what I mean.

But I understand your basic question is about taking advantage of currency rates. So let’s take another example

But let’s assume there was a VWRL traded in EBS in CHF and VWRD traded in USD on LSE. However the underlying instrument is always in USD. Because the underlying asset is same ISIN which is IE00B3RBWM25

So it doesn’t matter if you buy one share of VWRL or VWRD. You always buy the same ISIN. The price of both of these tickers would continuously adjust based on following

  • actual price of ISIN IE00B3RBWM25 in USD
  • actual exchange rate at moment of buy/sell CHF/USD

In order to ignore the price change of ISIN IE00B3RBWM25 between the time of buy and sell, let’s assume you can execute this at the same time so there is no change.

Now you want to take advantage of currency exchange rates by buying and selling these ETFs. You can try this for yourself but only thing you will achieve by doing all this is to

  • pay trading fees,
  • stamp duties etc and

end up same number of shares that you started with. So it’s a net loss for you.

VWRL and VWRD are real tickers and traded at EBS and LSE respectively. Both are unhedged so no impact of hedging.

You cannot buy VT in CHF on IBKR. It’s always quoted in USD and you always need to buy it in USD. IBKR offers automatic conversion of currency so it can use CHF funds to convert to USD and then buy VT shares. But the actual buy transaction is always in USD.