I don’t like foreign exchange. It’s not that there is anything wrong with switching money from one currency to another, it is just the expense, hassle and frustration it bears. For some people this may seem very strange – after all, the currency markets are the most efficient in the world with volumes of more than $5 trillion every day, but there is nothing more complicated in finance than managing currencies. In fact, I would argue that the biggest risk of any diversified investment portfolio comes from how you allocate your monies to the various mediums of exchange.
But let’s start at the beginning. We all have our base currency, e.g. the money that we use most in our daily lives, in which we draw income and pay our bills. If you live and work in the UK, then you probably care more about what Sterling does than the Japanese Yen. However, if you are going to invest outside of your domain, then there will be the risk that the exchange rate at the time you acquired an asset could change by the time you want to sell. That much is clear. The question is, what can we do about this risk and how much is it going to cost?
Lesson number one, hedging currency risk can be very expensive. Most of that has to do with the difference in interest rates from one country to another. For example, at the moment US Libor is 2%, whereas Euribor is -0.365%, which means it would cost 2.365% per year to hedge that currency risk. But that’s not all, the banks also need to make money, so they would charge an additional spread. Say, you want to hedge $10m into Euros. The current USD/EUR exchange rate (spot) is 1.1075, so to hedge our currency risk for one month, we would enter into a so called forward contract, which should theoretically trade at 1.1095 (spot plus 2.365%/12). However, when you look at the market, the price is actually 1.1102. Doesn’t look like much of difference, but that’s the thing about ratios, when you multiply them with large notional amount, even the third and fourth decimal point have a large impact. In our example, we would be paying $7,000 in commission and remember you have to do this every month for so long as you are in the trade, and of course, the interest rate differential would also cost $20,000 per month.
So, if you want to hedge your currency risk for the long term, it could cost you a fortune and to add insult to injury, the exchange rate may actually never move. Still think hedging all of your currency risk is a good idea? We can’t eliminate currency risk, because the cost is too high, but we also can’t ignore the risk either and all you have to do is look at what it happening in Argentina right now. You’re doomed if you try, and lost if you don’t. As always, the answer to our problems lies somewhere in the middle and hedging half of your risk back to your base currency seems the only sensible way to go. And please don’t try to take a view on the direction of currencies either, predicting the future we cannot. Have I mentioned that I really don’t like currencies?