News & Analysis at your fingertips.

We use a range of cookies to give you the best possible browsing experience. By continuing to use this website, you agree to our use of cookies.
You can learn more about our cookie policy here, or by following the link at the bottom of any page on our site.

0

Notifications

Notifications below are based on filters which can be adjusted via Economic and Webinar Calendar pages.

Live Webinar

Live Webinar Events

0

Economic Calendar

Economic Calendar Events

0
Free Trading Guides
Subscribe
Please try again
EUR/USD
Bullish
Oil - US Crude
Mixed
Wall Street
Mixed
Gold
Bullish
GBP/USD
Bearish
USD/JPY
Mixed
More View more
Real Time News
  • It seems the markets are riding high, but risk is always lurking around the corner. Consider your escape plan before you find yourself in collapsing market. What are the top havens for different conditions in 2020? Find out from @JohnKicklighter here: https://t.co/1oeXWEsJkb https://t.co/x8uyOHLtgE
  • The Swiss Franc may continue higher against the US Dollar as technical pressure favors USD/CHF bears..Get your $USDCHF market update from @FxWestwater here:https://t.co/yqJbbhAWiu https://t.co/CaMR0Vqd1m
  • The US Dollar lost ground to most ASEAN currencies as Emerging Market assets climbed despite US economic woes. USD/INR is eyeing third-quarter Indian GDP at the end of the week. Get your market update from @ddubrovskyFX here:https://t.co/urDN2b5Nwd https://t.co/toSDbVZCSi
  • The global stock market can be categorized into specific groups or ‘stock market sectors’. Organizing the vast number of stocks in this way helps traders to view assets in a more manageable way. Get your stock market sectors basics here: https://t.co/5gbiHmY8yl https://t.co/mQ6ty8Yalv
  • The Euro looks poised to continue gaining ground against haven-associated currencies and may reverse higher against the British Pound in the near term. Get your #Euro market update from @DanielGMoss here:https://t.co/oRIHju7ZzK https://t.co/dIEErVzWEY
  • Gold and silver prices have come under significant pressure recently. However, this correction lower could prove short-lived as price analysis hints at a reversal higher. Get your $XAUUSD market update from @DanielGMoss here:https://t.co/K1qL0fsGwy https://t.co/tRfjlN6X22
  • The S&P 500, Dow Jones and crude oil prices have recently made critical advances to the upside. Is retail positioning supporting the case for further upside momentum?https://t.co/rfA2TsBctB https://t.co/SNoOEVLXvA
  • An improving economic backdrop is bolstering crude oil prices and in turn, the Canadian Dollar. Still, the risk-sensitive Australian Dollar continues to move higher. Get your market update from @FxWestwater here:https://t.co/NJ683bZKpe https://t.co/zt3bYddjZ6
  • Gold Price Forecast: Dovish FOMC Could Underpin Bullion Ahead of NFP - https://www.dailyfx.com/forex/fundamental/forecast/weekly/chf/2020/11/27/Gold-Price-Forecast-Dovish-FOMC-Could-Underpin-Bullion-Ahead-of-NFP.html?CHID=9&QPID=917708&utm_source=Twitter&utm_medium=Moss&utm_campaign=twr #Gold #XAUUSD $GOLD $GLD https://t.co/N9ChZOqSdy
  • Forex Update: As of 21:00, these are your best and worst performers based on the London trading schedule: 🇪🇺EUR: 0.42% 🇦🇺AUD: 0.35% 🇳🇿NZD: 0.30% 🇨🇦CAD: 0.20% 🇯🇵JPY: 0.16% 🇬🇧GBP: -0.33% View the performance of all markets via https://www.dailyfx.com/forex-rates#currencies https://t.co/4uyJxc09OH
Introduction to Currency Overlay and Hedging Strategies

Introduction to Currency Overlay and Hedging Strategies

2011-12-09 07:53:00
David Schutz,
Share:

How would you like to make a successful investment, only to watch your profits diminish or even disappear on a technicality? Didn’t think so. It’s happened before, and you mustn’t forget that an investment in any foreign entity is also an investment in that nation’s currency. If the foreign currency loses value against your own currency, your returns could suffer when you convert them back into your own money.

To illustrate: “Joe” is a Canadian investor. In 2003, he invested in the S&P 500, an American equity index. Before sitting back to watch his stock grow, though, he converted his CAD into Greenbacks to make the investment.

The market boomed, and by 2008 the S&P was up 38%. But when Joe decided to take profit, he realized that his real earnings were nowhere near what they should have been. The reason? While Joe’s cash was sitting in US markets, the effects of the early 2000s bull market were not lost on the risk-correlated Canadian Dollar which more than offset his US equity profit. So strong were Canadian Dollar gains, in fact, that when he converted his 38% profit back into his native currency, he actually had 3% less cash than when he started out.

Introduction to Currency Overlay and Hedging Strategies

What is Currency overlay?

An astute investor like Joe, with enough foresight to liquidate his investment before the 2008 crash, should’ve known to hedge. Currency hedging (or currency overlay) essentially involves selling one’s native currency to offset any gains it might accrue over the investment period. Had Joe hedged, he would have sold USD/CAD (bought Canadian Dollars against the US Dollar) to the amount of his US investment.

It’s a win-win strategy – by 2008, Joe’s profit from his currency trade would have offset the decrease of investment return value caused by the appreciation of the Canadian Dollar versus the Buck during the same time. However, had USD/CAD climbed during this period, Joe’s losses would have been covered by the Buck appreciation, which would have made his S&P returns worth more in Canadian money.

Overlay strategies originated in Europe in the 1980s and have since spread as a popular way to eliminate currency risk. Today, with the availability of web-based forex platforms, any investor can successfully hedge a foreign investment.

Types of currency overlay

To add a twist, let’s say that in 2003 Joe had a long-term market view. Joe correctly foresaw the Canadian Dollar appreciating versus the Dollar, and wanted not only to hedge out his losses but to turn a profit. This marks the distinction between passive and active currency hedging.

A passive strategy focuses on complete elimination of currency exposure as described above. The hedge is equal to (or a fixed percentage of) the investment and enables the investor to focus solely on his investment without the worry of currency risk. These investors look no further, preferring to take their profits from the investment itself.

An active strategy, however, takes a position on market direction and seeks to profit while keeping risk at a minimum. For example: Joe could have varied the percentage of his currency hedge, based on market fluctuations and his short and medium term view of market movements, with the goal of beating his investment return benchmark.

If, for example, during the investment period he felt that there were times that the Canadian Dollar was at risk for weakness, Joe could have reduced his complete hedge and benefited from a short-term USD rise. Once he felt that the short-term USD rally had run its course, he could then look to fully hedge.

Hedging can be a complicated business, and many people hire professionals to do their currency hedging for them. This is often unnecessary – any smart trader should be able to execute a successful overlay strategy. Over the coming weeks and months, DailyFX will be running a series of articles on currency overlay, and what you can do to protect your foreign investment. Each piece will cover a different face of the dozens of strategies out there.

Judging by the amount of FX hedge funds springing up all over the world, currencies are becoming increasingly relevant in the investment word. We expect market volatility to only increase as the Euro crisis intensifies. Don’t miss out – hedge your market knowledge, just like your investments.

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

DISCLOSURES