Given the interconnectedness of today’s global economy, it is hard to imagine a medium-to-large size company that is not exposed to currency risk. Such risk can result from importing parts or components or from exporting finished products to foreign markets.
FX risk is not just for manufacturers, asset managers with large positions in foreign securities not only have exposure to the underlying asset value variability, but also face exposure to the currency in which that asset is priced.
In light of these considerations, risk managers are well aware of currency fluctuation risk to their business. One way to manage currency risk is with a currency overlay program.
The objective of a currency overlay program is to limit losses and maximize gains that arise from currency rate fluctuations. Strategies can be passive, active, or a combination of both.
FX Hedge Example
Consider a Brazilian asset manager who decides to allocate R$40 million into U.S. equities. By investing in U.S. equities, he has two risk exposures:
- U.S. equity price risk exposure
- U.S. dollar versus Brazilian real currency exposure
Currency Risk Exposure
For this example, we focus exclusively on the currency risk exposure. In order to invest in U.S. equities, the Brazilian asset manager must first convert his cash from Brazilian reais to U.S. dollars.
Starting position R$40,000,000
Brazilian reais to US dollars exchange rate = 4.00
This is 4 Brazilian real for each U.S. dollar
R$40,000,000 ÷ 4 = $10,000,000
The asset manager can now invest the $10 million into U.S. equities.
What is his currency risk?
By converting from Brazilian real to a U.S. dollar, he is now exposed to a weaker U.S. dollar. If the dollar goes down in value versus the Brazilian real, when he converts back to his domestic currency, he will receive fewer reais, reducing the return on his investment.
Creating the Currency Hedge
Brazilian real futures are quoted and traded in American terms. When the terms currency weakens, in this case the U.S. dollar, then the futures price increases. Therefore, to hedge a weaker dollar exposure our manager would be a buyer of the BRL/USD futures (contract symbol 6L).
How many contracts would he buy?
Hedge ratio = “value at risk” ÷ “notional contract value”
Hedge ratio = R$40,000,000 ÷ (BRL/USD contract notional = R$100,000)
Hedge ratio = 40,000,000 ÷ 100,000
Hedge ratio = 400 (6L) contracts
BRL/USD futures contract trade at the inverse price to the spot convention. The spot exchange rate was 4.0000, therefore the futures contract price would be 0.25000.
Spot USD BRL exchange rate = 4.0000
BRL/USD futures contract = 1 ÷ 4.0000 (or 0.25000)
This means our asset manager would buy 400 BRL/USD futures at a price of 0.25000.
Scenario: U.S. Dollar Weakens
New spot exchange rate = 3.5000
BRL/USD Futures price = 1 ÷ 3.5000 (0.28570)
Purchase price for BRL/USD contract = 0.25000
Price movement = 0.28570 – 0.25000 (3570 points)
If we multiply this increase by the 400 contracts we get a profit of $1,428,000.
Converting $1,428,000 amount back into Brazilian reais at the 3.5 exchange rate results in a gain of R$4,998,000 from the hedge.
If you subtract the gains from the hedge position from the loss resulting from the currency rate change results, we end up with a 2,000 reais loss for the asset manager.
Loss from exchange rate change = (R$5,000,000)
Gains from futures contract = R$4,988,000
Total hedge result = (R$2,000)
This small loss is certainly more acceptable than a R$5 million loss if left unhedged.
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