Hedging
HEDGING
Hedging is an act of protecting risk from currency fluctuations. The investor must decide whether to:
1. fully hedge (risk adverse)
2. Partly hedge
3. Not to hedge (risk taker)
Since most borrowing is for commercial transactions (i.e. buying/selling deals), investors tend to take some risk.
An American investor buys in Australia
Assume:
$AUD: $US (1990) = 0.85 (1.1765)
$AUD: $US (1995) = 0.75 (1.3333)
Bought in 1990 $AUD $100,000 ($US 85,000)
Sold in 1995: $AUD 150,000 ($US 112,500)
Profit is AUD $50,000 (50%)
BUT Real result is?.
Real profit = $US 112,500 - $85,000 = $US 27,000
Hence real return = 27,500 / 85,000 = 32.35%
The Return is less as the exchange rate has weakened.
Foreign Exchange Market
Foreign investors will often involve the use of the currency futures and option markets to hedge their positions. They can use:
1. Forward contracts ? used by the main players and can be made to measure e.g. banks for say 4, 6 or 12 months (we wont cover)
2. Futures contracts ? expire at certain times of the year and are in denominations of $100,000
3. Currency options ? provides you with an option but not an obligation, therefore is more expensive
4. Currency swaps ? combination of forward contracts (we wont cover)
Interest Rate Parity
"At equilibrium (all other things equal), the currency of the higher interest rate country will trade at a forward rate discount in terms of the lower interest rate country's currency".
Id = if + forward rate
Forward rate = -ve (discount)
+ve (premium)
The equation tells us that when hedging:
id(domestic) = if(foreign)
Hedging
HEDGING
Hedging ...