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BOOK YOUR FREE STRATEGY SESSION NOW >>When we trade instruments that are listed in foreign currencies, we're faced with what is known as "foreign exchange risk," which is the risk associated with changes in the exchange rate between our currency and the currency of the asset being used.
There are several solutions for managing foreign exchange risk, each of which has different advantages and disadvantages.
In this video, we'll look in detail at some of these solutions (the most widely used) focusing on the advantages, costs, and difficulties associated with each one, so it will be easier for you to find the right solution!
By watching the video, you'll discover everything you need to know about the 3 most common solutions for managing foreign exchange risk:
Buying foreign currency securities without holding that currency
Buying foreign currency in the cash market (to be used to buy securities)
Buying foreign currency in the cash market (to be used to buy the securities) by hedging with the corresponding futures
Enjoy! 😎
Introduction
Hello everyone and welcome to this brand new video! One of the coaches at Unger Academy here and today we’re going to be talking about foreign exchange risk.
There are many traders who invest in foreign markets, that is to say in instruments that are listed in foreign currencies. And in most cases, we're talking about people who trade on US securities and instruments but don't live in the US. This entails making choices related to the management of the liquidity in foreign currencies. And since many of you have asked us what are the best choices to make, in this video, we'll try to give you an answer. And we'll do it by making the example of a European trader who wants to trade on US securities listed in US dollars.
Possible scenarios
Okay, so regarding the topic of foreign exchange risk, we could consider a wide range of different scenarios for liquidity management. In this video, we wanted to show you just three scenarios that we believe are the most common among investors.
The first scenario involves buying a security in a foreign currency without owning that currency. This is the case, for example, of a purchase of Amazon shares using euros.
The second scenario, on the other hand, involves buying dollars and then holding the necessary liquidity in the portfolio to buy foreign securities.
The third and final scenario adds to point two a hedge using a future or other derivative instruments.
I'd like to point out that for the cost analysis for each of these three approaches we'll refer to the price list of one of the leading brokers available to us retail traders, namely Interactive Brokers.
Scenario 1
So, let's immediately take a look at the advantages and disadvantages of the first scenario. Well, assume that we have a portfolio totally in Euros and we want to go and buy an equity package or a dollar-listed asset allocation.
The advantage of buying such products using Euros is that, in all respects, we won't be exposed to foreign exchange risk, because we’re going to buy products in foreign currencies. Our broker will allow us to buy such stocks by going into dollar debt, and so we'll end up with a long position on, for example, a stock and a debt of the corresponding counter value of what we bought in dollars for liquidity.
The disadvantages of this scenario involve paying interest on the negative balance in foreign currency. Of course, any profit or loss received on the financial instrument listed in dollars will then be debited or credited in that currency to our account.
So, if we close a position in dollars at a profit, we'll receive a capital gain in dollars. Those dollars, of course, will be subject to exchange rate fluctuations. So, while it's true that we have no exposure at the opening of the position, everything that happens after that inevitably leads us to be unbalanced on the exposure.
For sake of clarity, let’s assume that we buy 10 shares of Apple stock at $140 each. This way, we'd end up with a debt of $1,400. If the price of Apple rises, for example to $280 per share, so it doubles, our dollar debt remains at $1400, but the counter value of the position we opened is $2,800. And so, the spread between these two positions will naturally be exposed to risk.
Because if I close the transaction and sell the 10 shares at $280 per share, I'll end up with $2,800 minus $1,400 of debt totaling $1,400, which I’ve effectively earned but is exposed to exchange rate risk.
Everything works the same way with futures. The profit and loss will never be covered by the exchange rate risk, unless, day after day, we want to cover ourselves with derivatives, but I guarantee you that it's a useless and above all very expensive effort.
Practical example
Let's see now how these things work in practice, so directly in the TWS. Now we are going to make a slightly more complicated example by adding a dollar part as well, but let's take a good look at what this is all about.
Here you can see a demo account that has half a million Euros and about $5,000. Let's try to buy a product listed in dollars. For example, we could take IDTL, which is an ETF listed in dollars that is widely used by Europeans.
Suppose, for example, that we go and buy a quantity of 500, which corresponds, as you can see, to about $2,200. In this case, we're going to do a "Transmit" or rather "Override and Transmit." Okay, this has been executed. Let's go and take a look at the portfolio.
You can see that our liquidity has gone down. The market value in dollars is $2,200. Our position has 500 stocks in this ETF. But what happens if we have to buy more? Or better yet, what happens if we didn't have these dollars?
Suppose that we buy more. Let's go and buy some more. So, we’ll go to "Order ticket" and buy 1,500 more stocks. Let's use a market order, perfect. See? It will be approximately $6,600, but we don't have that amount. We only have $2,500. We'll transmit the order. Here our market value will be $8,890 and we'll have a debt of $4,088.
Interactive Brokers allows us to do this. So, what are the costs of this $4,000 debt? Let's go look at it on Interactive Brokers.
So, we'll type in "Interactive Brokers" and go to the "Trading" section. This is a margin, in this case, a margin rate. All the costs are of course annualized, so if it is a 2%, 3%, 4%, 5%, it means a 2%, 3%, 4%, 5% per year.
Here you'll see, let's do the math. We already have the dollar currency set up and we'll enter our $4,000. "Calculate," and we're told 2.33%. This 2.33% is the price we have to pay to have a debt in this currency with this broker.
How is the calculation structured? So you see, the calculation goes in tiers, so let's go back and see what those tiers are. For debts under $100,000, there is a rate of 2.33%. For debts between $100,000 and $1,000,000, this rate will be applied, and so on. The same is true for all other currencies.
Scenario 2
Let's move on to the second scenario, in which we decide to buy dollars in the cash market. So, we'll have the dollars needed to purchase a foreign security.
The advantages are that we own the liquidity and therefore have no cost. Why no cost? Because we don't have to borrow dollars, we don't have to borrow euros, so we'll never be in debt.
However, the disadvantages are that we have total exposure to foreign exchange risk because when we buy dollars, we'll be at the mercy of fluctuations of the Euro-Dollar exchange rate.
Scenario 3
The third and final scenario starts from scenario 2 but adds a partial or full hedge using derivatives. So, in this case, we'll end up having liquidity in both dollars and euros, but we're going at the same time to buy a Euro-Dollar future. So, with the dollars on hand, we’re going to buy euros.
In this way, we'll have a partial or full hedging, depending on how well we can hedge our quantity. For example, the main futures contract has a counter value of €125,000. So, if we went to buy dollars with a counter value of €125,000 and then went to buy a future, we'd end up with a full hedge.
The disadvantages, of course, are the costs of this coverage. What are the costs of futures? And I'm not talking, of course, about the commission costs of buying the product or doing the rollover, although it still should be taken into account because it could be troublesome.
I'm talking about futures costs that are related to the price of the futures. To analyze this properly let’s look at the futures prices quoted right now. So, let's go to "eur fx cme".
Let's look at the quotes, for example, between June this year, 2022, and June next year. So, let’s go to the “Quotes” field and look for the last price. Now, if we wanted to buy a futures contract and hold it, let's say, for one year, the price we'd pay is exactly the difference between this June (June 2022) and this, June 2023.
Going to do a quick calculation with the calculator we’ll divide 1.097 by 1.07015 and we'll get 1.025, which is a number that can be definitely compared to this 2.33%.
Now the purists will maybe kill me after what I said, however, this isn't about arbitrage here, 2.5 on one side and 2.33 on the other, otherwise we'd do it right away. What I did was just looking at the last price of a contract expiring in June 2023. That's obviously an entirely illiquid contract, with an empty book. However, it helps us to understand that the annual percentages of taking on debt or hedging with futures are almost identical.
Deposit costs
Then there's the last cost, namely the costs that I called "currency deposit costs", in other words, the negative interest that our broker will charge us if we go and deposit cash, in this case, euros, we said at the beginning of this video, on our account.
Holding money in the IB account has a cost that depends on the currency that we've deposited. Let's go again to the Interactive Brokers website and see what this is all about. In this case, we're going to be talking about "Pricing - Interest rates," and in case we've deposited, let's say, €100,000 in our account, we need to choose the reference currency in euros.
Here it is. You can see that we aren't charged anything for amounts under $50,000. But a negative interest rate of almost 1% is applied for amounts of $50,000 and up. So, if we had €100,000 deposited in the account, we’d be charged 0.85% per year for only €50,000.
The more observant of you may have noticed that I added these deposit costs only to scenario 3 and scenario 1, so scenarios in which there is still a balance in euros. So, in scenario 1 we always had euros. In scenario 3 we also bought dollars, but we hedged with the futures, so we were left with a hybrid condition, with both dollar cash and euro cash. In this situation, we had assumed that we were only buying dollars, so we only had a dollar account. I didn't mark this cost because if we go and look at the Pricing for Interactive Brokers for dollar deposits, a positive interest rate is applied, so no longer negative, namely +0.33% per year will be credited for dollar deposits.
Of course, we are aware of the situation now with inflation at 6-7% and so of course in this case it would still be reflected in a loss to have dollars deposited on Interactive Brokers. However, I didn't add it as a cost item because as you see, interest rates are positive, unlike other currencies like the euro.
Final thoughts
Well, this does conclude the overview of the main scenarios we may encounter in managing liquidity in our trading account. Of course, there are many other facets and variables to consider.
I personally keep most of my liquidity in euros in my account and only a small percentage of dollars not hedged against foreign exchange risk, which acts as a bit of a buffer for possible strategy losses. It's an optimal solution for me, but it may not be so for someone else who perhaps uses the account for a different trade, or who prefers to be exposed to exchange rate risk.
Well, we really hope that you found this video useful and if you did, please share it and leave us a Like. We would really appreciate it.
And if you need help to start investing in the markets systematically, I'd recommend that you go and click on the link in the description below. It will take you to a page where you'll find many useful resources, including being able to register for a free presentation by Andrea Unger, or go and get our best-selling book, "The Unger Method" covering only shipping costs, or even book a call with a member of our team to get some free strategic advice.
And lastly, I remind you to subscribe to our channel so you can stay updated on the release of any and all of our new videos and our new free content.
And with that, I will see you soon with a new video. Until then, bye-bye!
We'll help you map out a plan to fix the problems in your trading and get you to the next level. Answer a few questions on our application and then choose a time that works for you.
BOOK YOUR FREE STRATEGY SESSION NOW >>Andrea Unger here and I help retail traders to improve their trading, scientifically. I went from being a cog in the machine in a multinational company to the only 4-Time World Trading Champion in a little more than 10 years.
I've been a professional trader since 2001 and in 2008 I became World Champion using just 4 automated trading systems.
In 2015 I founded Unger Academy, where I teach my method of developing effecting trading strategies: a scientific, replicable and universal method, based on numbers and statistics, not hunches, which led me and my students to become Champions again and again.
Now I'm here to help you learn how to develop your own strategies, autonomously. This channel will help you improve your trading, know the markets better, and apply the scientific method to financial markets.
Becoming a trader is harder than you think, but if you have passion, will, and sufficient capital, you'll learn how to code and develop effective strategies, manage risk, and diversify a portfolio of trading systems to greatly improve your chances of becoming successful.
