How to Hedge Your Currency Risk

Let’s say you absolutely love a stock but despise the currency of the country it comes from.

The United States comes to mind. The US Federal Reserve is about to commence with a policy of cutting interest rates that could last a year. That means the greenback is about to become the weakest currency in the world. Look at the ten-year chart below and you’ll see that a major double bottom for the Aussie may be taking place.

Most American technology stocks are likely to gain 30% or more over the next two years. However, it’s entirely possible that the US dollar declines by 30% or more against the Australian (FXA) and Canadian (FXC) dollars during the same period. Making 30% and then losing 30% leaves you with precisely zero profit.

There is a way to avoid this dilemma that would vex Solomon. Simply hedge out your currency risk. I’ll use the example of the Australian dollar as we have recently had a large influx of new subscribers from the land down under.

Let’s say you want to buy AUS$100,000 worth of Apple (AAPL), the world’s most widely owned stock.

Since Apple is listed on the New York Stock Exchange, its shares are denominated in US dollars. When you buy Apple in Australia, your local broker will automatically buy the US dollars for your account to settle this trade in the US, taking out a small commission along the way. You are now long US dollars, thus creating a currency risk.

Getting rid of this currency risk is quite simple. You need to offset your US dollar long with a US dollar short of equal value. Long dollars/short dollars give the Australian investor a currency-neutral position. The US dollar can go to hell in a handbasket and you won’t care.

There are several financial instruments with which you can do this. Buying Invesco Currency Shares Australian Dollar Trust ETF (FXA) is the easiest. This ETF invests 100% of its assets in long Australian dollar/short US dollar futures and overnight cash positions.

I’ll do the math for you on the final hedged position assuming that the Australian dollar is worth 70 US cents.

BUY AUS$100,000 long US dollars X US$0.70 cents/dollar = US$70,000.

US$70,000/$210 per share for Apple = 333 Apple shares

BUY US$70,000/$70 (FXA) price = US$1,000 shares of the (FXA)

Thus, by owning AUS$100,000 worth of Apple shares and 1,000 shares of the (FXA), you have completely removed the currency risk in owning Apple. You have in effect turned Apple into an Australian dollar-denominated stock. Apple can rise, the US dollar will fall, and you will make twice as much money in Australian dollars.

There are a few problems with this precise trade. The liquidity in the (FXA) is not great, especially during US trading hours. Understandably, the bulk of Aussie liquidity takes place during Australian business hours.

There are other instruments with which you can hedge out the currency risk of Apple or any other US dollar-denominated investment.

You can take out your own short dollar position in the futures market. You can ask your bank to create a short position in the US dollar in the cash market. Or, you can simply ask your broker to hedge out your US dollar currency risk for which they will charge you another small commission.

Hedging out currency risk is not only free, the market will pay you to do it. That’s because Australian dollar overnight interest rates at 1.00% are lower than US dollar overnight interest rates at 2.50%. By shorting Aussie against the buck, you get to keep this 1.50% interest differential.

You don’t have to be Australian to want your Apple shares denominated in Australian dollars. In fact, hedge funds do this all day long. They pursue a strategy of keeping their long position in the world’s strongest securities (Apple), and their short positions in the world’s weakest securities (the US dollar). This, by the way, is also the strategy of the Mad Hedge Fund Trader. It’s called “global long/short macro.”

The better ones often make money on both sides of the equation with the longs rising and the shorts falling. You can do the same in your own personal online trading platform.

I should urge a word of caution here. What happens if you hedge out your US dollar risk, and the dollar continues to appreciate? Then you will get none of the gains from that appreciation and will end up losing money in Australian dollars if Apple shares remain unchanged.

In the worst case, if both Apple and the Aussie could go down, this accelerates your losses. So, currency hedging can be a double-edged sword. Yes, this may be irrational given the fundamentals of the Aussie and Apple. But as any experienced long term trader will tell you, “Markets can remain irrational longer than you can remain liquid.”

Many thanks to John Maynard Keynes.

Australian Dollar Overnight Interest Rates

 

Looks Like a Good Bet to Me