An obvious problem faced when trying to hedge the foreign currency risk of a foreign investment is its uncertain future value. Managers use various strategies for managing the currency risk of a foreign prortfolio, including
- hedging a minimum future value below which they feel the portfolio will not fall
hedging the estimate future value of the portfolio
hedging the initial value
None of these strategies can eliminate all the currency risk. for eg, even if management has determined a minimum future value below which the portfolio will not fall, they are still exposed to values above that.
can someone explain the bolded parts that are related?
lets say i have a portfolio of $10m and i feel that the worst possible FV is $9m. so i hedge the portfolio at $8.9m?
- hedging a minimum future value below which they feel the portfolio will not fall
Buy ATM put spreads on exchange rate (assuming they are long the currency). For instance, if it’s a 90/100 put spread, they are hedged up to a 10% decrease in exchange rates. Draw a diagram if you have trouble visualizing.
-even if management has determined a minimum future value below which the portfolio will not fall, they are still exposed to values above that.
Using the same example above, if the exchange rate falls more than 10%, the put spread is passed the lower strike. That is, they are no longer hedged.
-lets say i have a portfolio of $10m and i feel that the worst possible FV is $9m. so i hedge the portfolio at $8.9m?
You have a $10mm portfolio and buy a 90/100 put spread (ignore the cost of the put spread for now). If the exchange rate falls to 95% of the original value, you are protected by the put spread. If the exchange rate falls to 90%, you are protected. However, if the exchange rate falls to 89%, you lose 1%.
can u illustrate it using Futures instead of options? the mechanics of futures is different from puts where long/short a future will have to deliver unlike an option where it can just expire out of the money.
lets say we hedge at $8.9m that is lower than the $9m expected. we may be wrong on the $9m “worst case senario” valuation so hedge with futures @ $8.9m makes sense.
…they are still exposed to values above that. does it mean the portfolio will may drop even further to say $8.5m? but hey, we have the futures to cover that, no? or is it the case where portfolio may drop to just $9.5m instead of the WCS senario of $9m and we have to deliver the futures at $8.9m hence incurring further losses?
if the portfolio value today is 10M$ - and it earns returns of say 10% during the year – it will be 11 M$.
If you hedged the portfolio using an estimated future value of 11M - and the portfolio was exactly at 11 M a year later - the hedge fully covers you. However say the portfolio was only 9.5 M$ - or it became 12M$ - you are not covered. The hedge will work against you.
Typically in these cases - you hedge only the principal - so your hedge would be for 10 M$.