FX forward rates and hedging costs
Investors that use FX forwards to manage risk on foreign investments typically observe that their forward contracts lock in a loss or a gain relative to current spot exchange rates. This loss or gain equates to a drag or enhancement on the overall investment returns which should be factored into deal underwriting.
Consider the example of an investor based in the U.S. investing in Japan, with an intent to liquidate their investment in one year. The investor must buy JPY at the spot exchange rate (let’s assume that it’s 108.79) to make the investment and, to hedge the risk of movements in the spot rate between now and when they want to repatriate their capital, locks in a forward to sell JPY for USD in one year at a forward rate of 105.75. This locks in a USD gain of 2.8%.
This gain is reversed to a loss for Japanese investors investing in the U.S. They would buy USD in the spot market at 108.79 and at the same time sell USD forward at 105.75, locking in a JPY loss of 2.8%. This highlights that hedging not only reduces FX risks but also can enhance or reduce investment returns.
Below are examples of the loss or gain from the perspective of USD, EUR, and GBP investors.
USD capital invested in foreign countries
EUR capital invested in foreign countries
GBP capital invested in foreign countries
Need more specific indications or analysis?
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.21-0173
Our featured insights
Capital markets and accounting considerations in real estate M&A
Mergers and acquisitions involve a multitude of complexities and risks. Speed and accuracy at every stage of an acquisition is critical to not only winning the deal but also giving the transaction the best chance of financial and strategic success. Financial risk associated with the valuation of...
FX — choosing different hedging strategies and when to opt for an option
An FX option is an insurance policy, usually bought by way of a cash premium. It is deployed as a hedging strategy when flexibility is required and/or when its holder has a particular view on future currency movements.
The president, the stimulus, and the dollar
With Joe Biden’s feet firmly under the Resolute desk in the Oval office, and having just signed one of the largest stimulus packages in U.S. history, it seemed appropriate to look at the impact on the USD and financial markets in general.
What does 2021 hold for European interest rates and foreign exchange?
2021 sees the removal or reduction of major uncertainties for the market. The agreement of the Brexit trade deal and the roll-out of COVID-19 vaccines are both providing a welcome boost. Some risks remain, and new ones will emerge. What are the areas to look out for in interest rates and FX markets?
Always prepare for the unexpected in FX markets
Unexpected events in the FX markets can have a significant impact on the cost of hedging and a business or fund’s liquidity.
The components of FX option pricing
An FX option is an insurance policy on an exchange rate. Its pricing is determined by factors including time to expiry, strike rate, and volatility of the underlying currency pair.
Hedging GBP currency risk through Brexit
This piece examines what currency movements are telling us about Brexit risk, and provides a look back at milestones over the past three years. Hedging GBP risk is not just about fixing a forward rate; a more flexible approach and adoption of hybrid tools can provide optimal protection.
Foreign exchange hedging – time to reassess?
Approaching FX hedging can be complex, given the need to consider the interplay between global markets and the challenges of assessing both costs and benefits. This piece will address some misconceptions about the costs of FX hedging and provide insight for a reassessment of your FX hedging stance.