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In my previous job, a fund of funds, they used 3 months forward FX contracts (renewed every 3 months) to protect their portfolio against currency risk.

If I do understand why forwards are useful for fixed schedule (like bonds with coupons at fixed periods). I don't understand why it is protecting the portfolio's positions against currencies risk during the undetermined positions lifetime time.

Maybe, I'm unclear. So, here is an example:

  • The portfolio is in USD.
  • It has 3 positions, 2 in USD and 1 in EUR.
  • The EUR position needs to be protected against EUR/USD variation.
  • Positions can be held during an unknown period (over a year maybe).

With renewed 3-months FX forward, your EUR position is protected only for 3 months. When the contract ends, you get a new one with a new "price" close to current spot and not close to the initial investment spot rate.

Am I missing something? I was told, this is the most efficient way.

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If I can easily compute the portfolio value while un-hedged. But how can I do that with that kind of risk protection? –  humble.jok Jun 15 '13 at 17:30
    
Forwards may have been used to match the exposure amount as opposed to futures which have an amount set by the exchange. As for the choice of 3-month term structure I dont know, a longer term mean a higher (counterparty) risk –  Filip Jun 17 '13 at 13:45
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2 Answers

up vote 6 down vote accepted

The majority of the movement in currencies is in the spot rates, rather than in the term structure. A 3-month rolling hedge would always be protecting against movements in the spot rates, no matter when they happen.

Using your example, if the current EUR/USD rate is 1.3333, you might be able to get a 3-month forward at 1.3339. (Forgive me if I have the direction wrong here, I haven't touched FX in years.) If the spot rate jumps to 1.2000 by the time your 3-month forward expires, you will have 0.1339 in profits to protect you from losses in your position. If you are then able to roll the hedge to a new 3-month forward at 1.2006, you still keep the 0.1339 in profits. When you finally exit you EUR position, you might only get 1.2000 for it, but you have 0.1339 in profits from that first forward. Therefore the hedge has worked, absorbing the vast majority of your currency losses.

This rolling hedge would fail if the underlying were something where the term structure was more active. Take natural gas. If you have a natural gas position -- say a producing field that will come online in an unknown number of years into the future -- then making 3-month rolling hedges would not provide much protection. Natural gas in 3 months is very uncorrelated with natural gas in 3 years.

To the extent that currency term structures do change -- meaning a move in the relative interest rates of the two countries -- you would not be protected very well. You would only be protected for the remaining life of the current 3-month forward, not for the months or years between that forward's expiration and your underlying position.

Since your old employer says that 3-month rolling hedges were the most efficient, they probably did their research. Multi-year forwards are not nearly as liquid as 3-month forwards, and they would have paid a larger bid/offer to their bank/counterparty. In the USD/EUR case they could have used Eurodollars vs. Euribor futures to hedge the interest rate risk, but the transaction costs there are not low either, and they'd have to worry about margin. They probably decided that the risk was small and the cost of a more complete hedge was high.

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This only works for fixed investments without any future cash flows so I agree with you. Just wanted to point out if we talk about assets that involve future cash in or outflows then forward strips are a very bad idea. Think of airlines which need to hedge against future price increases in kerosine. They are only insulated for the duration of each forward thus the exercise turns more into predicting future cash flows rather than pricing forwards. –  Matt Wolf Jun 19 '13 at 2:11
    
What do you recommend then? My new employer (who's from my previous company ;) ) wants to replicate that behaviour. –  humble.jok Jun 19 '13 at 6:53
    
Nothing wrong with that approach as I said as long as there are no contingent cash flows. –  Matt Wolf Jun 19 '13 at 14:56
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The price of the Forex Future is linked to the Spot Rate by the following formula:

spot * exp(rate difference * years)

Choosing a 3-month time horizon is indeed quite common for "manual" hedging when the holding period of the positions is quite long.

Yet the higher your trade frequency (in your case concerning the EUR position), the more often you need to adjust your hedge. If you have to do it on a daily basis (or even more frequently), it might make sense to use a Trading platform for this purpose.

Two additional Notes on this topic:

  • There are actually three different contract sizes for the EUR/USD FX Futures: 2'500, 62'500 and 125'000 USD. We use the large ones to do the main portion of the hedge and mostly keep it for the entire 3 months. In addition we use the medium ones to adjust the hedge on a weekly basis
  • Also, some Brokers (e.g. InteractiveBrokers) provide virtual Spot Positions which essentially remove the when-to-roll question.
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...and why you advertise here and post completely unrelated content? Downvoted. I just do not see any value added in what you wrote. Everyone can look up the spot-forward relationship, your software has nothing to do with anything here and contract size and interactive brokers are adding even more to the reader leaving in a confused state...and your constant advertising slowly starts to get annoying...but I thought you were already told that by several moderators –  Matt Wolf Jun 19 '13 at 15:00
    
I did remove links to AlgoTrader. But I do not agree with your comment. FX Hedging is actually something quite tricky and we spend quite a bit of time figuring out the best way to do this. My tip, if you can use Virtual Spot Positions for hedging, do that, as they are a better hedge than FX Futures. –  Andy Flury Jun 19 '13 at 15:40
    
Hedging fx exposure is quite simple, relatively speaking. And it certainly has nothing whatsoever to do with virtual positions as you mentioned. Euro exposure is euro exposure no matter what. The term virtual spot position does not even exist. Its a term used by interactive brokers to delineate fx spot positions from fx exposure that arose from cash flow generating other assets. –  Matt Wolf Jun 19 '13 at 16:56
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