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Rolling Hedges and Short Hedges

Mitigate Foreign Exchange Rate Risk

 

Foreign Exchange (FX) hedging can be a useful tool when seeking to mitigate foreign exchange rate risk. Notably, for businesses that have a predictable cash flow from a foreign country in a foreign currency, rolling hedges may be useful in protecting that business’s cash flow from swings in foreign exchange rates.

While businesses can use FX hedging to insulate from foreign currency conversion loss due to an unexpected shift in a foreign exchange rate, FX hedging can also prevent that business from realizing a gain in foreign currency conversion should the foreign exchange rate experience a favorable shift.

While an unexpected bump in cash flow from a favorable foreign exchange rate shift is a welcome surprise to most (if not all) businesses, some businesses are willing to forgo this potential upside or gain if it means guaranteeing, through FX hedging, that they will not experience an unexpected shortfall in their cash flow due to a detrimental foreign exchange rate shift.

 

 

What is a Rolling Hedge in Regards to FX Hedging

 

A rolling hedge is a strategy through which businesses maintain a number of FX hedges through futures and options, with varying expiration dates, in order to have a certain percentage (or all) of their expected cash flow from foreign markets hedged against foreign exchange rate fluctuations. It can help to visualize a rolling hedge as a conveyer belt of hedge positions: as one executed FX hedge position (through the use of futures contracts, or put or call options, or a combination) expires, there is already another FX hedge position right behind it to take its place, and another one behind that one, and so on and so on.

These FX hedge positions do not have to be identical: they can be for varying amounts, varying strike prices, etc. Thus, the rolling FX hedge position can be tailored to a business’s cash flow and foreign exchange needs.

 

Businesses can utilize a rolling hedge to manage their global cash flows, as well as an FX hedging tool, on a continuous basis. Instead of simply reviewing their foreign exchange exposure and setting up an FX hedge once a year, businesses can dynamically manage their FX hedging on a quarterly, monthly, or even weekly basis. One important side benefit of utilizing a rolling hedge is that it forces a business to earnestly look at its international cash flows, as well as its foreign exchange exposure, on a regular basis. It is important to note that unlike most futures contracts for commodities, such as wheat, metals, pork, oil, etc., which generally are not closed out for delivery but are instead rolled over into other future contracts or closed out for cash, foreign currency futures contracts are, quite often, exercised for delivery upon expiration, meaning the fund is bought out before a new contract is purchased.

 

 

What is a Short Hedge in Regards to FX Hedging.

 

 

A short hedge, in regards to FX hedging, is a strategy that seeks to mitigate an FX risk (a currency risk) which has already been taken. The reason it is referred to as a short hedge is because a security (in this case, a foreign currency derivative contract, such as a forward contract or a call or put option), is shorted. By shorting this derivative contract, the trader (or business) is able to hedge (protect or mitigate themselves from risk of loss) against their long investment in the underlying asset (the foreign currency).

If the short hedge is executed properly, then losses resulting from the long position in the underlying foreign currency will be offset from the gains in the short derivative position. Conversely, if the foreign currency gains in value, which would result in a gain to the trader or business, those expected gains will be offset by the losses resulting from the short derivative position.

 

 

Example

 

For example, let us say that today, Euros are trading at US$1.00 per Euro. The currency trader expects to receive a payment in the form of EUR1,000 on June 1st (meaning, the trader is now “long” in Euros, since Euros will be received). Worried that the value of the Euro may drop between now and June 1st, the trader enters into a short hedge, by promising to sell 1,000 Euros via a forward contract, expiring on June 1st, at US$0.90 per Euro. If the price of the Euro on June 1st is US$1.10, the currency trader will still net US$1.00 per Euro, because while EUR1,000 is being received as payment, worth US$1.10 per Euro (so, US$1,100) the trader is short because of the forward contract, promising to sell to the other party in the forward contract EUR1,000, at a price of US$0.90 (so, US$900).

 

 

By selling those 1,000 Euros below market value, the trader is incurring a loss of US$200 (because those 1,000 Euros are now worth US$1,100 on the open market). But, the currency trader received an extra US$100 by receiving the payment of 1,000 Euros on June 1st, because those 1,000 Euros are worth US$1,100. The net effect is a wash, and the original payment of 1,000 Euros is still effectively worth US$1,000. In this manner, the trader, or business, can execute an FX hedge against currency fluctuations, to ensure that the expected cash flow of 1,000 Euros will equal the expected currency exchange of US$1,000, and not suddenly more or less.

 

While giving up the potential gain, the business guarantees no potential loss, so that cash flow and budgeting can be accurately forecast, without fear of an unexpected cash flow shortfall which could hinder paying suppliers, lenders, employees, or other obligations.

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Correlation Trading

In the world of financial trading, asset correlation establishes how and when the prices of different financial instruments move in relation to each other. With regards to currencies and forex trading, correlation is the behavior that certain currency pairs exhibit where they either move in one direction or in different directions, simultaneously:

A currency pair is considered to be positively correlated with another if their values move in the same direction at the same time. A good example of positively correlated currency pairs is the GBPUSD and the EURUSD. When the GBPUSD trades up, so does the EURUSD.

A negative correlation between currencies occurs when there are two or more currency pairs that trade in opposing directions simultaneously. A good example of this phenomenon is the USDCHF and EURUSD. When the USDCHF falls, the EURUSD often trades up, and vice versa.

Types of Correlation

 

There are three recognizable forms of asset correlation: positive, negative and no correlation. If two assets’ prices move up or down in the same direction simultaneously, they show a positive correlation, which could be either strong or weak.

However, if an asset tends to move down when another rises, then the correlation is negative. The level of correlation is measured as a percentage figure, from -100% to 100%, also known as a correlation coefficient and it is established by analyzing the historical performance of the assets.

For instance, if two assets have a correlation of 50%, it means that, historically, when one of the assets’ value was rising or falling, there was a corresponding rise or fall in the same direction in the value of the correlated asset, about 50% of the time.

Conversely, a -70% correlation means that analysis of historical market data shows the assets moving in opposite directions at least 70% of the time. A zero correlation means that the asset prices are completely uncorrelated. This means that the movement of the price of one asset has no noticeable effect on the price action of the other asset.

It is also essential to understand that the fact that correlations exist on average over a period of time, does not necessarily mean they exist all the time. Currency pairs or assets that may be highly correlated one year, could diverge and show a negative correlation the following year.

If you decide to try out a correlation trading strategy, you need to be aware of times when the correlation between assets is strong or weak, and when the relationship is shifting.

Correlated Assets and Asset Classes

 

It is common to find correlations between the most heavily traded currency pairs and commodities in the world.

For instance, the Canadian dollar (CAD) is correlated to the price of oil since Canada is a major oil exporter, while the Japanese yen (JPY) is negatively correlated to the price of oil as it imports all of its oil. In the same way, the Australian dollar (AUD) and the New Zealand (NZD) have a high correlation to the prices of gold and oil.

Airline stocks and oil prices.

Stock Markets and gold offen, but not always.

Large-cap mutual funds generally have a high positive correlation to the Standard & Poor’s (S&P) 500 Index.

Correlation-Based Trading Strategy

 

While positive and negative asset correlations have a significant effect on the market, it is vital for traders to time correlation-based trades properly. This is because there are times when the relationship breaks down – such times could be very costly if a trader fails to quickly understand what is going on.

The concept of correlation is a vital part of technical analysis for investors who are looking to diversify their portfolios. During periods of high market uncertainty, a common strategy is to re-balance a portfolio by replacing a few assets that have a positive correlation with some other assets with a negative correlation to each other.

In this case, the asset price movements cancel each other out, reducing the traders risk, but also lowering their returns. Once the market becomes more stable, the trader can start to close their offset positions.

An example of negatively correlated assets that are used in this type of trading strategy is a stock and a Put Option on the same stock, which would gain in value as the price of the security drops.

Why Is Asset Correlation Important to Investors?

 

In the world of investment and finance, asset correlation is studied closely since asset allocation is aimed at combining assets that have a low or negative correlation in order to lessen portfolio volatility. Having a combination of assets with a low correlation reduces the portfolio’s volatility. This gives a trader or portfolio manager room to invest aggressively.

What it means is if a trader is ready to accept a certain amount of volatility, then they can put their money into high return/risk investments. This combination of low/negatively correlated assets in order to lower volatility to acceptable levels is known as portfolio optimisation.

 

Risk Management Tips for Correlation-Based Strategies

 

Sound risk management is essential when making investment decisions in order to lower the adverse effects if you suffer a loss. By using the modern portfolio theory, it is possible for you to reduce your overall risk within your portfolio of assets, and possibly even boost your returns overall, by investing in positively correlated assets.

This strategy will allow you to capture and mitigate for small divergences as the asset pair stays highly correlated overall. As the divergence of the asset prices continues and the correlation begins to weaken, you need to carefully examine the relationship to find out if the correlation is deteriorating. If so, you should exit the trade or take on a different trading approach in reaction to the change in the market.

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Dealing in the Spot Market

Dealing in the Spot Market

An effective forex trading strategy does not have to be limited to only forward contracts. At times, Trading foreign currency directly in the spot market, at the current spot rate, is the most effective strategy for a business to minimize its costs or maximize its profits. Sometimes, it can be more profitable to execute a currency exchange at the current spot rate to take advantage of favorable pricing for a product, or to receive payment immediately from a client, regardless of what the current spot rate is. But even when transacting in the spot market, there are various tools a firm can use to maximize its profit (or minimize its loss) on the currency exchange. There are various types of trade orders a firm can utilize in a foreign currency strategy, which give flexibility in limiting the price at which it can buy or sell a currency in the spot market, to prevent surprises should prices rise or drop while the currency exchange is being executed. Some of these trading tools are briefly outlined here:

Limit Order

 
Limit orders are used to buy or sell a specific amount of a foreign currency at a specified exchange rate (or better). A buy limit order will only be triggered at the specified FX rate (or lower); whereas a sell limit order will only be triggered at the specified FX rate (or higher). For example, a business places a buy limit order to exchange $10,000 U.S. Dollars for Euro, but only if the Euro spot rate reached $1.10 or lower.

Stop Loss

 
A stop loss order protects the value of a business’s currency holding by establishing a “floor” on an acceptable exchange rate. This floor represents the maximum the business is prepared to lose on the currency trade: if the value of its currency holding declines below the floor, the holding is liquidated (sold) to ensure that the business doesn’t lose value (or if the floor is set below an exchange rate in which there is already a loss of value, it can serve to limit further losses).

One Cancels Other (OCO) Order

 
By combining a limit order with a stop loss order, and adding the condition that if one of these orders is triggered then the other is canceled, a one cancels other (OCO) order is created. For example, an OCO order can be used to set an upper limit order and a lower stop loss order at which a currency holding is to be sold. If one is triggered, the other is cancelled, thus the currency holding is free to trade within this pre-set range.
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Currency Management

Institutional investors are increasingly managing multiple currency exposures in today’s global financial markets. Our currency management service provides foreign exchange execution and currency hedging solutions to help minimize risk, reduce costs and increase efficiency.

Investors need to carefully balance portfolio risk and return. While global diversification offers the opportunity of new alpha sources, it also introduces currency exposure risks.

We build our solutions to meet your specific currency management needs; whether you require share class hedging, portfolio hedging or portfolio hedging at a share class level. As an outsourced service, we take direction from you.

An automated, straight-through process

Prior to implementation, your dedicated project manager will work with you to ensure all the program’s parameters and requirements are communicated and documented. Our analytics team will determine optimal parameters for your consideration and decision. The team will closely coordinate with data agents and focus on automation to help mitigate risk and improve efficiency.

Share class hedging

Our focus is on operational risk control and performance of the share class. To manage risks, we use customized modules designed to systematically import and verify data from various agents, while for performance, our process focuses on benchmark pricing. Our goal is to maintain the target hedge while considering variations due to both net-asset value changes and investors inflows and outflows. All cash flows are executed at a benchmark spot rate to correspond with the valuation rate used in fund valuation and accounting. We aim to reduce the impact of data lag by executing currency trades attributed to changes in net asset value (NAV) as soon as practicable. We can accommodate flexibility in hedged tolerances, benchmark index current exposure usage, forward contract tenor, proxy hedging, and counterparty rules and limitations.

Portfolio hedging

Our portfolio hedging solutions focus on removing operational risks while considering the trade-off between tracking error and transaction costs. Tracking error associated with a rules-based overlay is caused by a combination and rebalance frequency, hedge filters and interest rate differentials. More frequent rebalancing can increase transaction costs and less frequent rebalancing can cause higher tracking error. Our sophisticated simulations help to illustrate the relationship between transaction costs and tracking error.

Traditionally, a strategic hedging policy in a rules-based strategy defines a target ratio to apply to foreign currency exposures. We apply this target hedge ratio to your portfolio exposures to determine the amount of currency to be hedged. This will operate within a band that is either a percentage of target hedge ratio or an absolute value. This will help to eliminate trades resulting from noise.

Benchmark hedging

You can access two types of benchmark hedging services:

Benchmark weight hedging involves hedging exposures based on the currency weights of a published unhedged benchmark. This is frequently used by active and semi-active funds, where FX-related tracking is often due to interest rate differentials, hedge ratio and investment ratio mismatches, and transaction costs and data lags.

Currency-hedged benchmark replication involves hedging exposures based on the currency weights of a hedged benchmark, commonly used by passive funds where FX-related tracking error is due to unrealistic benchmark construction rules and transaction costs.