Why does hedging FX risk matter to you? July 14, 2023
Everyone experiences foreign exchange (FX) risk one way or another, knowingly or unknowingly. Some examples include:
- Traders who buy shares of US companies
- Investors who put their money in unit trusts, or funds, based in other currencies
- A company selling its beverage to other countries
- A retail shop selling clothes bought, or imported from suppliers in Thailand and Hong Kong
- A student going for an overseas exchange programme in Australia
- Holiday seekers travelling to Japan
Simply put, if you would like to keep your assets in Singapore dollars, activities related to overseas instruments such as stocks and bonds, could put you at risk of suffering losses when FX rates go wayward. FX rates can have a significant impact on portfolio returns. The easiest way to show this is with the following example:
A Tale of Two “Currencies”
In his research on Amazon.com, Mr Tan found that it was undervalued on 2 November 2022. To capture opportunities of the price appreciating, he converted his Singapore Dollars to US Dollars and purchased 1,000 shares of Amazon.com at US$95.00. After holding on to this investment for a few months, he was delighted that the price of Amazon.com rose to US$102.00 at the start of February 2023. He quickly sold 1,000 shares to capture profits. Upon calculation, he was happy that he made US$7,000 (see calculation below).
Mr. Tan wanted to change his USD back to SGD so that he could make investments in Singapore shares. Upon conversion, he found it strange that a higher account balance was not achieved and investigated why. To his horror, he realised that the USD to SGD exchange rate had gone against him. Instead of making US$7,000 in profit, he incurred a loss in terms of SGD.
So, what is FX Hedging?
FX hedging refers to a strategy of minimising risks that come with transactions denominated in foreign currencies. Since FX rates can have a significant impact on portfolio returns, investors should consider hedging this risk where appropriate. Traditionally, FX hedging involves trading currency futures, forwards or options, or purchasing the currency itself. The relative complexity of these strategies has hindered widespread adoption of FX hedging by the average investor.
FX Contract For Difference (CFD) provides an easy, cost-effective way for retail investors who wish to mitigate exchange rate risk. FX CFD rates refer to the price at which a currency e.g. USD can be exchanged for another e.g. SGD. The exchange rate will rise or fall as the value of each currency fluctuates against the other. FX CFD only requires a small deposit known as margins, of the full contract value to establish the hedge position, allowing you to maximise your capital with other forms of investments. You can enter and exit FX CFD positions anytime, and enjoy a high level of flexibility to handle long-term exposures or specific event risks.
It is a fairly simple concept. If you place funds in US assets e.g. stocks, you should short (or sell) USD relative to SGD to hedge. If USD loses value (also known as depreciating) causing value loss in your US assets relative to SGD, the hedge would profit. Conversely, if USD is gaining in value (also known as appreciating), the hedge will suffer losses. The hedge, by definition, counterbalances the unpredictable exchange rate swings of the US assets relative to SGD value, allowing investors to concentrate on price fluctuations of the US asset itself.
FX CFD is the answer to your hedging needs
Simply open a CFD account to hedge your exposures to various currencies. Taking the above example, if Mr. Tan had sold 10 mini lots of USD/SGD CFD (10,000 notional per mini lot contract) at 1.4200 as an FX CFD hedge, he would have covered his 95,000 exposure in US dollars. When the USD started to move unfavorably against him, his hedge would gain on the depreciation in USD. Eventually, when he does sell his US shares, he could also exit his hedge at 1.3100.
- Profits on FX CFD hedge = (1.4200 – 1.3100) x 10 mini lots x 10,000 per mini lot = S$ 11,000
- Capital requirements on FX CFD hedge = 5% margins on 100,000 = US$5,000
- Cost of hedge = 0 (FX CFD is zero commissions and has zero financing charges)
- Swap Rollover (estimated accumulation holding USDSGD.FX.CFD for 3 months) = -0.0050
Don’t Exchange Rates Also Change Favourably?
It is true that exchange rates may change favorably as it does unfavorably. Although this might be the case, majority of investors and businesses aim to focus on where their expertise lie and not depend on currency changes.
Reducing/ Removing FX risk as a variable
FX CFDs can actually protect your portfolio from unexpected FX risks and aid you in reaching your investment goals. Alternatively, investors can use FX CFDs to hedge on short-term event risks such as economic data releases or corporate news announcements.
“I can just wait until the FX rate swings back”
Foreign exchange markets are volatile. As such, FX rates to swing back potentially. However, if we see the following charts, it can be seen that for certain currency pairs some of these levels are never seen again.
The chart above shows the USD/SGD for the past 15 years. The currency pair may take months or even years to return to that level. As investors/traders, we might not be able to wait for such long and unknown periods before being able to safeguard the FX conversion value.
At the extreme end, the SGD/JPY has been appreciating since 2013, highlighting the importance of hedging FX risk to reduce/eliminate FX risk exposure. As FX rates can deviate largely across time and “waiting until FX rate to swing back” will be costly to traders and investors.
In conclusion, everyone experiences FX risk directly or indirectly. FX risk can be extremely costly during times of volatility. By using FX CFDs to hedge FX risk, traders can minimise or even eliminate FX risk, therefore becoming immune to the movements of the FX markets, which can be very unpredictable. With a small contract size of US$10,000 of the base currency, traders can hedge with ease and avoid the risk of over hedging.
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Reference:
- [1] https://www.bound.co/blog/fx-hedging-for-beginners-how-to-reduce-foreign-currency-risk#:~:text=Simply%2C%20FX%20hedging%20helps%20people,are%20trading%20in%20foreign%20currencies
- [2] https://www.linkedin.com/pulse/5-reasons-why-most-people-lose-money-stock-market-sumit-chanda/?trk=articles_directory
- [3] https://www.investopedia.com/articles/forex/09/exchange-rate-risk-currency-etf.asp
- [4] https://www.credit-suisse.com/ch/en/corporate-clients/products/international-business/foreign-exchange/optimally-hedging-foreign-exchange-risks-in-uncertain-times.html
- [5] https://www.valutrades.com/en/blog/forex-hedging-what-is-it-and-how-do-you-use-it
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About the author
Kenneth Tan (Head of FX CFD) and Sam Hei Tung (Dealing)
Kenneth Tan graduated from Nanyang Business School with a Master of Science in Financial Engineering. Having worked as a spot and NDF trader for a top bank in Japan and an option dealer with one of France's top five banking groups, Kenneth has devoted more than 15 years to developing the FX business and strongly believes that investing in FX instruments is essential to every investor. He enjoys learning about how automated strategies can enhance trading experience for clients.
Sam graduated from National University of Singapore with a Master of Science in Finance. He personally manages his own investment portfolio and does equity and economic research in his free time. Sam believes that education and information is essential to making good financial decisions.
