Foreign exchange risk can impact overseas property assets, and potentially erode their returns in the event that the value of a currency moves against you.
A popular approach to hedging the sale of an overseas property is to fix the value of the sale using an FX derivative – such as a forward exchange contract – immediately after the sale of the property is settled. This means locking in the exchange rate for the sale (and the income generated from it) at the point at which it is confirmed, so that the return achieved is made certain and is protected from any potential adverse moves in exchange rates.
However, other derivative products can also be used to hedge property prices – such as CFDs. This strategy would involve opening a CFD position on a forex pair, so that any profit to that position balances out or partially reduces the decline in the property returns.
Let’s say you’re a UK-based investor, who is planning to sell a property in Spain in six months. At the current EUR/GBP exchange rate of 0.89800, your €245,000 villa is worth £220,010 (245,000 x 0.89800). You’re concerned that the pound will strengthen against the euro, which would lessen the value of your foreign investment.
To hedge your foreign exchange exposure, you decide to take out a short EUR/GBP CFD – buying the sterling while selling the euro. One EUR/GBP contract is worth €100,000 so you would need to take an exposure equivalent to 2.45 contracts to balance the currency exposure of your €245,000 villa. For IG clients, one contract is the equivalent of £10 per point, so 2.45 contracts would give you 24.50/per point. You’d open your position to sell EUR/GBP at the current bid (sell) price of 0.89790.
Once you’d placed your short CFD trade, if the pound did strengthen against sterling, the profit to the CFD position would mitigate some of the loss in value of the property. If the price of EUR/GBP fell, you might decide to close your trade at the ask (buy) price of 0.87800. The market would have moved by 200 points in your favour – earning you £4900 (200 x £24.50).
At the same time, the price of your property would have been adversely impacted by this decline in the value of EUR/GBP. At the new spot price of 0.87800, your Spanish villa would be worth £215,110 – a loss of £4900. This loss would now have been hedged by the profit to your short CFD trade.
Had your prediction been incorrect, and the pound did not appreciate, the loss to your CFD trade could be partially offset by the advantageous exchange rate on your property sale.
Currency risk can rapidly erode profits, especially in times of high volatility. As a result, when exposing oneself to overseas markets, whether that be through a traditional investment, a sale of a property, a commercial purchase, or receiving income, a view needs to be taken about currency risk. Some may feel comfortable with the risk of exchange rate volatility, and wish to try to take advantage of it. Others would prefer not to have such uncertainty. In any event, the risks associated with foreign exchange ought to be considered to ensure one’s personal objectives are not compromised.
To start hedging currency risks, there are a few steps every trader should follow. These are: