So I get really confused as to which currency should be on top when we do a currency hedge. For example, if I’m a US investor investing in Europe, that means I would want to sell Euro futures, so does that mean i short USD/EUR? Also, is this the same thing as longing a EUR/USD contract, or are they different? Thanks in advance!
I think you would want to protect yourself from a EUR deppreciation (get fewer USD back) so you would short the EUR in a currency futures contract. You are “betting” that in the case of a EUR deppreciation you would get paid off.
Hope I got this +/- correct…
The term USD/EUR would mean Dollars per Euro , and as a US Investor you want more dollars end the deal. So you want to go long the dollar and short the euro. Which means you buy a USD/EUR contract on a european bank or futures exchange or sell a EUR/USD contract on a US bank or futures exchange.
The item you’re selling appears on top for a short .
so dean99 , you would do the opposite : if you want to sell Euro currency you want to short Eur/USD forward or futures
Hi Janakisri- Thanks for your response . . . that’s what I thought, but can you look at the last question on the 2008 essay exam? In that problem, you are a Japanese investor hedging a US investment and you short a JPY/USD contract.
I think maybe it doesn’t really matter what currency is on top in this case because either way you are locking in this rate? Does anyone have any insights?
janakisri,
if you want to protect from a devaluation of the EUR, wouldn’t you have to long a EUR/USD (EUR per USD) futures contract?
If EUR/USD goes up then the EUR is devaluating and this is precisely what you want to hedge, being long? You do not have to hedge the EUR appreciation.
Isn’t this correct?
Appreciate your help once again if possible…
many thanks
Tigas- If you are holding tinvestment in foreign currency (i.e. holding the Euro in this case) the you would always short that currency. The only time you would long is if, for example, you expect to make a payment in the future.
A forward on a currency is not prepaid . It is an exchange done at a future date at a rate struck today. If you need to short JPY in dean99’s example , you agree to deliver JPY and receive dollars at an agreed rate. You already know the notional in JPY . So you agree to deliver that notional in JPY and the other party agrees to deliver fixed amount of dollars . You stand to gain on the hedge at least if JPY depreciates or in other words dollar appreciates because u gain more appreciated dollars than if you had no hedge . So the only way to resolve this in my own head is to consider short the currency the same as short a forward contract on it . So it would be short JPY/used.
janakisri and dean99’s, thank you both for your help. I made considerable progress but I believe there is something reversed in this last good explanation, therefore I need your help again if possible.
In dean99’s example:
“…In that problem, you are a Japanese investor hedging a US investment and you short a JPY/USD contract…”
You are shorting a JPY/USD because if the exchange rate decreases (less JPY per USD = USD depreciates) you are covered by the contract that you made.
You are not hedging yourself from a USD appreciation or JPY depreciation, but the opposite in my opinion.
Let’s say the make the forward contract JPY/USD at 1.50. At maturity it decreases to JPY/USD 1.35. As you are short this forward JPY/USD (you both say this and I agree) you will stand to win because you will not suffer from the devaluation of the USD. You stand to gain on the hedge from a USD depreciation (not appreciation).
If the USD appreciates/JPY depreciates you must pay the counterparty of the forward contract but it will be offset from the currency gain you get on your USD investment.
Could anyone shed some light on this?
many thanks,
when you short a contract - you are doing so in expectation of a currency depreciation. If the currency appreciates - you would always lose - some gains on your portfolio will be offset by a loss on your futures contract.
A futures / forward contract always has this two sided nature. To get the benefit - and have a one sided contract - you need a currency option contract. but there - you are either paying (holder of the contract, long side) or are being paid a premium (seller of contract or short side) to take the position you are in.
Togas ,I think you are mixing up swaps and forwards. If you contract to deliver a certain notional USD as a Japanese investor , you will have to deliver it exactly that many USD anyway . There is no way to pay more or less. Similarly you will receive exactly the JPY contracted for from your bank , no more and no less. This does not depend on appreciation or depreciation. You are both locked into the rate for the forward. Only in a swap would you have one or the other party make a net payment and the other gets a net receipt.
that’s precisely my point CP (I really meant that with my last post! Finally 
many thanks ALL for your inputs.
cheers
Another question on this topic:
If interest rates are low in the US and high in the UK, lets say there is an interest rate differential of 4%—
it says in the book that an an american investor heding the brithish pound risk has to pay the interest rate differential, while a british investor heding the us dollar receves it.
…It seems to be the reason why the journal suggests that american should not hedge their british investments, but that but that the british investors should hedge their us investments.
why should british investors hedge their us investments, assuming interest partity holds, the usd should appreciate, so no hedge would be necessary?
i am specifically refering to questions 5 in the topic currency risk mgmt. (p. 327)
British investor is going to receive US Dollar, then he needs to convert it into British Pounds - and when he does that he will receive fewer pounds.
Ques 5 _Currency risk mgmt.
YC in US < GB
Suggests that keeping inflation constant, real int rate are higher in britain than in US. So if IRP holds good, Dollar should depreciate (Pound should appreciate)
US investor who are invested in british stocks (i.e. in Pound currency) will get more dollar due to pound appreciation at the time of converting back their investment in dollar terms. Hence they need not worry about currency hedging.
British investors invested in US stocks are vulnerable to dollar depreciation. If dollar deprciates they will get fewer pound at the end of closing their investment & converting it back into Pound, hence they should do currency hedging against dollar depreciation by shorting US /Pound future or buying Pound/ US future.
if you short US$/ Pound - you agree to deliver US $ & receive pound from the long side.
If you long Pound/ US $ - you agree to receive pound & deliver dollar
Rahuls,
Isn’t it "…real int rate are higher in britain than in US. So if IRP holds good, Dollar should appreciate (Pound should depreciate )… ?
If USD will appreciate relative to GBP, according to IRP (lower US rate than UK rate), a british investor will convert USD to his domestic currency and get more GBP.
I just don’t get why he “receives” the IR differential nor why he should hedge (and the american does not need to hedge?)
really appreciate your thoughts on this.
many thanks
USD Rate (USD/UK) = Spot (USD/UK) * USD Interest Rate / UK Interest Rate
USD Interest Rate / UK Interest Rate < 1
So USD Rate will fall. It will depreciate.
Thanks CP,
If USD/GBP falls, means you need less USD to get 1 GBP, so USD will appreciate (is stronger).
Am I totally burned out???
When cpk says the rate falls , he means GBP/USD falls or USD:GBP rises in fx slang. Simply put GBP appreciates , so you get more USD per GBP
[original post removed]