Currency Hedging and Exposure: Part III

Finally, I get to actual practical hedging strategies. But, first, I'll explain something about forex futures contracts. These are the contract sizes of the smallest futures contracts available in a few different currencies:

Euro E-Mini E62,500
Australian Dollars $A100,000
Yen E-Mini Y6.25 million

$A100k is the minimum trade size. You can't trade only $A50k, for example.

To gain exposure to $A100,000, for example, you put down a margin of $US1000 and the value of your deposit then varies based on the underlying contract value. So if the Australian Dollar rises by 1 US cent your deposit becomes $US2000. If it moves the other way you have zero and must put up more margin (you actually need to do this as soon as the margin deposit falls below $US1000) or sell the contract. You can also short sell a contract to get negative exposure to the same amount. Short selling a contract means creating a new contract - the same as short-selling an option. But unlike selling an option you don't receive money up front for the contract - money flows into your account only if the value of the underlying asset falls. All these contracts are relative to the US Dollar. Shorting a contract converts an exposure to that currency into a USD exposure.

My net worth is $US350,000.$US87,000 or 25% is in US accounts - My 403(b) ($33k), Roth IRA ($8k), Ameritrade trading account ($26k), Interactive Brokers account ($10k), HSBC Online Savings Account ($9k), Checking Account etc. My Australian accounts have $US267k or $A349k.

Therefore, if I buy 1 AUD contract I convert $US77k of my USD exposure into Australian Dollars. I now have only $US10k of exposure to the US Dollar left. If I want to eliminate my Australian Dollar exposure I could short-sell 3 to 4 AUD contracts. Short selling 3 leaves me with $A49k exposure to the AUD. If I short-sell 4 contracts then my net US Dollar exposure is $US395k (4*77k+87k) and a net negative Australian Dollar exposure.

The preceding paragraph is one possible hedging strategy. If I am bullish on the USD I would short 3 AUD contracts and if I am bullish on the AUD I would buy one AUD contract. This will swing my exposure from almost all US Dollars to almost all Australian Dollars.

But, as I discussed in my previous post, that isn't a very diversified approach. To get a diversified currency exposure I could short sell 2 AUD contracts and buy 1 Euro and 2 Yen contracts. The resulting exposure is (here I resort to a spreadsheet!):



The net USD exposure is reduced because I converted $US154k of Australian Dollars into US Dollars but then bought $US186k of Euro and Yen. This results in an effective USD loan of $US32k (you don't actually borrow the money it is implicit in the contracts you are entering into). Borrowing money in a currency is just like shorting that currency. Because, my account is still relatively small, I can't avoid the lumpiness of the resulting exposure. Here is another example portfolio which is more bullish on the AUD (but still ends up shorting it!):



I short one AUD contract and buy 1 Yen and 1 Euro. It's possible to get net short in some of the currencies, but I think that is speculating rather than hedging and diversifying and not something I want to do. At least at the moment.

Right now I am long one AUD contract. My USD exposure is, therefore, 3% and my AUD exposure 97%. This hyperbullish stance on the Aussie probably doesn't make a lot of sense.

Currency Exposure and Hedging: Part II

Diversifcation makes sense in currency trading in the same way it makes sense in stock trading and investing. For example, in the last couple of days I thought the US Dollar would fall. Turned out I was right but the Australian Dollar also turned out to be weak. So just buying Australian Dollars did not turn out to be the way to profit from the move in the USD. In retrospect the Euro would have been the best choice. One couldn't have known that upfront but being diversified away from the US Dollar - holding say AUD, Euro, and Yen would have been a better strategy than just buying the Aussie. Don't put all your eggs in one basket.

Currency Exposure and Hedging: Part I

Most investors don't think about currency exposure and leave their portfolio in the currency of their home country. When they invest in foreign assets they may consider their currency exposure and either try to take advantage of changes in the value of the foreign currency relative to their own currency or hedge it away. For small investors this usually means buying a fund that hedges the foreign currency exposure back into the domestic currency. But currency exposure is a choice even if it is a default choice. If you don't do anything about it you do not have a neutral exposure but probably a big exposure to your home currency. Now, if you are for example a US investor it may make sense to have a portfolio denominated in US Dollars as when you get to actually spend some of the money you will be spending in US Dollars if you are still living in the United States. Diversifying runs the risk that if the US Dollar gains value against foreign currencies over time your portfolio will lose value in US Dollar terms. But if the US Dollar loses relative value over time diversifying would result in gains.

For an international investor like myself with 75% of my net worth in Australian accounts and 25% in US accounts, who isn't sure what country he or she will be living in in the future, currency strategy becomes much more important. From a low in 2001 of less than 50 U.S. Cents the Aussie rose to around 80 cents in 2004-5 and is now trading around 77 U.S. Cents. As most of my assets were still in Australia when I moved to the US in 2002 I gained tremendously from the rise in the Australian currency. Since moving to the US I have sent considerable savings back to Australia when the AUD was at a level that I perceived as attractive.



I don't know if the Aussie Dollar will keep rising. It is no longer undervalued like it was at the beginning of the decade and 80 U.S. Cents has provided resistance during the last decade. On the other hand, I don't see any compelling reasons to cause it to fall. So now we are in more of a trading environment.

As my net worth has grown the absolute dollar value of changes in the exchange rate have of course increased. My Australian Dollar exposure is $A341k. Therefore, a 1 cent move up or down in the Aussie changes my net worth in USD terms by $US3410. That's very nice when the Aussie is rising but not good news when it is falling. The changes in my net worth measured in Australian Dollars are much less of course.

I'll discuss different hedging strategies in upcoming posts.

The 24 Hour Forex Market

The chart shows the last day's trading in Globex Australian Dollar Futures. I sold my position on Sunday evening when the market seemed like it might be beginning to trade down. It's good that I did because around 2am EST the price collapsed and my stop would have been hit. Just before 5am though the market began to rally. Note that these times are 7am and 10am in London, the world's biggest foreign exchange market. Currently the price is above my sale price...

This shows why this market is best for either hedging or a very small level of speculation for overnight trades, or for daytrading, though often the big moves are happening in the middle of the night for US traders. Globex futures allow 80:1 leverage in Australian Dollars and some spot currency brokers allow larger levels still. This is where naive traders can quickly lose large amounts of money by being tempted to leverage too large positions on a seemingly small margin deposit. I'm definitely going to continue to step very gingerly in this market.

Closed My First Australian Dollar Futures Trade

Made $US64.30. Got in @ 0.7683 and out @ 0.7690. Each 0.0001 is worth $US10 on a single contract trade. Hopefully this won't follow the pattern of the NASDAQ 100 futures (NQ) where my first trade made money and the second trade was a losing trade. I entered this trade Friday after the steep rise in the US Dollar and fall in the Australian Dollar after the unemployment report came out on Friday morning. I did some technical analysis over the weekend, which showed that there was a significant chance that we were now in at least a short term downtrend. So I got out this evening with a small profit. I had a stop in anyway but if the chances seem stronger that the pullback will continue why take the risk of ending up losing money? But I don't feel certain enough about that to short the Aussie and right now have too little equity in my account to do both that and buy an NQ contract. I put some more money in my account but it is on hold till Wednesday :( I bought one NQ contract @ 1714 as the model is long. The model is predicting the Republicans will retain control of congress or if the Democrats gain control Bush will veto any moves they make to raise taxes on stocks. That has to be the implication of expecting the market to rise through the end of the coming week?