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Currency-Hedged ETFs - Forex Hedging Strategy
What Are Currency Hedged ETFs
Global markets provide investors with opportunity to invest in diversified portfolios of assets. There are many exchange traded funds (ETF) that specialize in investing in various portfolios designed to provide well diversified exposure to different markets. Investing into ETFs means investing into the mix of assets in the proportion the ETF is designed, providing exposure to specific market segments.
When a portfolio of assets includes assets denominated in foreign currencies, the return of such portfolio will depend on exchange rates of these currencies too. To eliminate that additional risk many ETFs include protection from exchange rate uncertainty. These hedge funds are known as currency hedged ETFs.
How do Currency-Hedged ETFs Work
Currency-hedged ETFs comprise foreign assets, usually a mix of foreign stocks or bonds, and a contract designed to protect against the movements of exchange rate. Often the contract that hedges against the exchange rate risk is a currency-forward contract. These forward contracts effectively lock in a predetermined future exchange rate so that the underlying investment in foreign assets can be converted into the local currency at a certain exchange rate at a future date. In doing so, they eliminate the uncertainty linked to exchange-rate movements. They also protect against changes to the outlook of interest rates in the home come country and abroad.
A forward exchange contract is an agreement under which a counterparty agrees to buy a certain amount of foreign currency on a specific future date. The purchase is made at a predetermined exchange rate. By entering into this contract, the investor in foreign assets can protect itself from subsequent fluctuations in a foreign currency's exchange rate. The function of this contract is to hedge a foreign exchange position in order to avoid a loss.
Then a currency-hedged ETF and a non-currency-hedged ETF issued by the same provider and tracking the same index will use the same asset allocation. The difference is that currency-hedged ETFs typically use forward exchange contracts to hedge against exchange rate fluctuations.
The value of the forward exchange contracts corresponds to the value of the ETF’s assets. If the home currency strengthens it thereby reduces the value of overseas investments because it is now worth more foreign currency today than it was before, and foreign investment returns get translated back into home currency at higher exchange rates. Then the forward contracts should gain enough to offset losses. If the home currency weakens then the forward contracts should lose enough to remove any currency gain.
In most instances, the forward contracts in currency-hedged ETFs expire at the end of each month, so portfolio managers must sell a soon-to-expire contract and purchase a new one to maintain an ETF’s hedge.
ETF providers usually recover their currency hedge costs through a slightly higher Total Expense Ratio (TER). The TER is the estimated annual cost of owning an ETF. These are the charges that get quoted on a product’s website or in the Key Investor Information Document (KIID). They involve costs like management and operating costs incurred by the ETF provider for index tracking, custodian fees for keeping ETF securities in a separate custody account at the ETF's custodian bank, licence fees for the index the ETF tracks, distribution fees for costs incurred for the marketing of the product.
Many currency-hedged ETFs are 0.1% to 0.3% more expensive per year than their unhedged counterparts. However, occasionally there is no cost differential at all.
Forex Hedging Strategy
Foreign currency hedging is a strategy aimed at protecting one's position in a currency pair from an adverse move. It is usually employed for short-term protection when a news or an event is expected to trigger volatility in currency markets. A forex hedging strategy usually involves using either currency pairs for hedging or using forex options. Let us consider the use of currency pairs for a forex hedging strategy.
Multiple Currency Pair Hedge Strategy
A simple forex hedging strategy would be opening both a buy and sell position in the same currency pair. However, after the 2009 recession the US Commodity Futures Trading Commission issued a new regulation and banned this practice. Another foreign currency hedging strategy is the use of three currencies for opening two buy and one sell position on their pairs.
Let us consider the trio of USD, EUR and GBP. For these currencies there are three currency pairs: EUR/USD, GBP/USD and EUR/GBP. A forex hedging strategy for these pairs can be opening a long EUR/USD, GBP/USD and a short EUR/GBP positions simultaneously.
As is evident, in this case a trader will hold one buy and one sell trade for each of those three currencies. This strategy can be employed with any combination of three currencies. Such a forex hedging strategy is completely legal and at the same time allows a trader to hedge his or her trades from potential losses.
Carry Trade Hedge Strategy
A carry trade is a trading strategy that involves borrowing funds at a low-interest rate and converting the borrowed amount into another currency with a higher interest rate to re-invest in an asset that provides a higher rate of return.
Interest rates play a key role in the carry trade strategy. The strategy aims to capture the difference between the rates, and profits can be substantial depending on the amount of leverage used. So, a trader chooses one low interest rate currency and one high interest rate currency and a simple carry trade can be executed by short selling the low interest rate currency and buying the high interest rate currency.
South African rand, Brazilian real, Indonesian rupiah and Indian rupee have been most popular high interest rate currencies while the Taiwan dollar, Hong Kong dollar and Singapore dollar have been traditional low interest rate currencies. Other favored low interest rate currencies for carry trade in recent years have been the Swiss franc and Japanese yen, while the Australian dollar and New Zealand dollar were two popular high interest rate currencies. Since currencies are traded in pairs, a simple currency carry trade can be implemented by buying AUD/JPY or NZD/JPY through a forex broker.
Alternative carry trade strategies could be implemented by using currency forwards, bank deposits, sovereign bonds or corporate bonds.
Let us say we pick the Swiss franc and New Zealand dollar as the low and high interest rate currencies respectively for our carry trade. Currently the base interest rate of the New Zealand dollar is 5.25% while the base rate of the Swiss franc is 1.5%. This means there is a gross interest rate difference of 3.75% between them. So by buying NZDCHF and holding it for a year, we can earn a “positive carry” of +3.75% in interest rate spread if the spot rate remains constant: we will receive 5.25% from long NZD position and pay 1.5% from short CHF position!
Our profit could be much higher if we use leverage: we could earn 37.5% annual interest a year on an account that is 10 times leveraged!
However the exchange rate uncertainty constitutes a significant risk that can render a carry trade a losing proposition and cause huge losses if high leverage is used. In case of our simple carry trade strategy, a significant strengthening of the Swiss franc or weakening of the New Zealand dollar or both simultaneously will result in decline of NZDCHF that will amount to losses for long NZDCHF positions.
And a high leverage used will magnify those losses, wiping out accumulated profits and eroding the trading capital. Financial markets studies indicate dramatic exchange rate movements occasionally happen without fundamental news announcements. The large depreciation of the US dollar against the Japanese yen on October 7th and 8th of 1998 is an example of such exchange rate movement that caused huge capital losses for carry traders.
Carry trades therefore are considered the domain for institutional investors with thorough market knowledge and ample funding.
Foreign currency hedging is used as a tool to hedge against exchange rate risk in carry hedge strategies. A popular foreign currency hedging strategy in carry trade is to buy “out of the money” currency put options to cover the downside in the carry trade.
A put option is said to be “out-of-the-money” if the underlying spot exchange rate is currently more than the strike price of the option. The reason for using an “out of the money put” is that the option premium (cost) is lower but it still affords the carry trader protection against a drawdown.
For our simple carry trade example mentioned above, a trader would buy NZD/CHF put option to protect his trade in case the CHF rises in value against NZD.
Conclusion
Investments in foreign assets entail currency exchange risks besides other risks associated with foreign assets. Traders can protect their trades from currency uncertainty by using forex hedging strategies such as employing currency forward contracts or currency options contracts. Both strategies are not cost free but provide protection from losses in case exchange rates move against the trades.
