help with hedging currency risk example

[type]

Hi

I have a question I needed help on. Regarding hedging out currency risk on an investment on both long and short sides, but needed a practical answer. All answers will be welcome and helpful! thanks in advance.

1. Lets assume we are trading CFD products on margin in the UK. My account currency is denominated in GBP/Sterling.
2. I wish to commit £2000 on margin on CFD, I leverage 4 times my amount, I can buy up to £8000 worth of stock.
3. I wish to buy £4000 worth of Apple stocks
4. I also wish to short/sell £4000 worth of Microsoft stocks
5. Both are sold and bought in US dollars on the NYSE or NASDAQ exchange.
6. The current exchange rate is say 1.8. So 1 pound = 1.8 dollars
7. This means I can buy or sell up to £8000 x 1.8 = $14400 worth of US Stock
8. I will commit £4000 ($7200) to each position
9. Apple share price is at $200 so I buy $7200 worth of stock. Which is 36 shares.
10. Microsoft share price is $400, so I short sell $7200 worth of this stock, which is shorting 18 shares.

How do I hedge out the currency risk fluctuations on both long & short positions? using the spot forex market. (no futures or options, I just want to use spot forex).

I assume, do I short sell £8000 worth of GBPUSD (short the Dollar, by going long GBPUSD) which is basically buying 0.08 lots on the spot forex market (denominated lot size by most forex brokers) to hedge out currency risk on both my long/short positions? or am I wrong?

All answers will be welcome and helpful! thanks in advance.

Many Thanks
type

 

[gc1]

If you're doing a spread trade on two U.S. stocks (long apple, short Microsoft) then you have little or no currency exposure, no ?

Using spot forex for hedging is generally a poor idea as the daily swap rate or roll-over costs add up over time. Not too bad for a position lasting a week or two but you presumably are looking longer term.

 

[type]

Hi gc1

Thanks for your reply. Yes it makes sense now. I am doing a spread trade.

But lets assume:

1) what if I bought $4000 dollars worth of Apple
And sold/sell short $3000 dollars worth of Microsoft.

Likewise

2) what if I bought $3000 dollars worth of Apple
And sold/sell short $4000 dollars worth of Microsoft.

How do I hedge the currency in those separate 2 scenarios? (these are now uneven positions because of beta hedging, a more realistic example)

My positions generally last 3 months.

Thanks

If you're doing a spread trade on two U.S. stocks (long apple, short Microsoft) then you have little or no currency exposure, no ?

Using spot forex for hedging is generally a poor idea as the daily swap rate or roll-over costs add up over time. Not too bad for a position lasting a week or two but you presumably are looking longer term.

 

[gc1]

Well, if you are long the stock your are short the currency and if you are short the stock you are long the currency, so if you wanted to hedge it should to be for the net amount (-$1,000 or +$1,000).

Daily swap rates at spot retail brokers are usually around 2% pa over the currencies interest rate differential, so holding a hedge for 3 months would cost roughly 0.5% of the notional position value. A relatively small amount but an extra cost.

 

[type]

Hi gc1

Thanks for your reply. This is really helpful.

if you are long the stock your are short the currency - are you are short on GBP or on the USD?

The way I figured it is this...please correct me if I am wrong below?

• If I buy £4,000 of Apple Stock
• and I short £3,000 of Microsoft Stock
• My difference is £1000, so in order to hedge.. I need to go long on the GBPUSD by 0.01 lots (buy £1,000 worth of GBPUSD).

Second Example:

• If I buy £3,000 of Apple Stock
• and I short £4,000 of Microsoft Stock
• My difference is -£1000, so in order to hedge.. I need to go short on the GBPUSD by 0.01 lots (sell £1,000 worth of GBPUSD).

Is this correct then?

Many Thanks

Well, if you are long the stock your are short the currency and if you are short the stock you are long the currency, so if you wanted to hedge it should to be for the net amount (-$1,000 or +$1,000).

Daily swap rates at spot retail brokers are usually around 2% pa over the currencies interest rate differential, so holding a hedge for 3 months would cost roughly 0.5% of the notional position value. A relatively small amount but an extra cost.

 

[Sigma-D]

Yes you're correct.

In your first example (buy £4k/sell £3k) you've effectively given yourself a net long exposure of £1k in USD. If the dollar weakens and/or sterling strengthens during the period you hold these stocks your net exposure increases in that your dollars will buy fewer pounds on conversion after closing your position. To negate that exposure you'd need to buy £1k of Cable which will (approximately) offset the currency fluctuation element.

Why you'd want to trade these two specific stocks in the manner you suggest is a mystery as they seem extremely positively correlated. I presume is just by way of an example rather than any genuine trading setup.

 

[Sigma-D]

You could also look at currency options and futures as you scale up those figures as each of these types of instrument will provide various forms of cover at various costs for your exercise, each with their own benefits and drawbacks.

 

[type]

Hi Sigma-D

Many Thanks for your response, it makes sense and is really helpful!

Yes the 2 stocks are just an example, I do not trade conventional stat arb trades, I rather look to see if the stock will outperform the other by way of fundamental predisposition.

I have a bit more complex pair trade example now:

1. Lets assume I want to perform a trade cross country pairs trade where I have a weak long bias on europe, but I think Sweden will outperform France.
2. Lets assume we are trading CFD products on margin in the UK. My account currency is denominated in GBP/Sterling.
3. I wish to buy 45700 Swedish Krona of Swedish Stock A (say £4000 worth)
4. I also wish to short/sell 5000 Euros of a French Stock B (say £4000 worth)

In order to hedge my currency risk in this trade assume we use spot forex.

1. I need to go short on the GBPSEK by 0.04 lots (sell/short £4,000 worth of GBPSEK)
2. I also need to go short EURGBP by 0.05 lots (sell/short 5000 euros worth of EURGBP), short because the currency is quoted the other way round (EURGBP not GBPEUR).

This should hedge out the currency risk on both trades. Is that correct?

I am not familiar with implementing options or futures to hedge. I am aware of the theory of these products.. just not up to scratch on the implementation of them.

Many Thanks

You could also look at currency options and futures as you scale up those figures as each of these types of instrument will provide various forms of cover at various costs for your exercise, each with their own benefits and drawbacks.

 

[Sigma-D]

The process you would use in any situation such as those you're discussing is identical to that you've already outlined in your previous examples. You hedge your net currency exposure against your sterling account.

 

[type]

Hi Sigma-D

Thanks you for your reply & help.

Yes, the reason why I gave a different practical example is to help myself and others who maybe reading this, understand what to do for different pairs e.g. EURGBP (quoted the opposite way around to say GBPUSD). It can get confusing for some newbies to grasp the core concept. So examples really help.

Many Thanks

The process you would use in any situation such as those you're discussing is identical to that you've already outlined in your previous examples. You hedge your net currency exposure against your sterling account.

 

[gerryg]

1. I need to go short on the GBPSEK by 0.04 lots (sell/short £4,000 worth of GBPSEK)
2. I also need to go short EURGBP by 0.05 lots (sell/short 5000 euros worth of EURGBP), short because the currency is quoted the other way round (EURGBP not GBPEUR).

This should hedge out the currency risk on both trades. Is that correct?

I would call it risk diversification rather than hedging. Virtually I don't see any cut in your risk. If you go wrong with both of forecasts you will take a bashing more than trading with one of the pairs. I tried beforewith Hot forex to find some patterns of currency mutual dependence and price inefficiencies but came to conclusion that trading under hovering menace of getting banned because of "arbitrage" is not the best way to dispose my money.:cheesy: