Hedging GBP/USD Risk Through Options

[Rationalize]

Quote from lightrader:

And if the stock goes to 0 and the GBP/USD goes to 2.2, will I not have more risk as opposed to a situation in which I just hold the stock?

Also, why not just buying out of the money put on the GBP/USD futures or XDB? Or finance this put by selling out of the money call and creating a collar that will narrow the spectrum of the exchange rates to which I will be exposed? I know it will not be a perfect hedge but I don't search for a perfect hedge. I search for a hedge against substantial changes in the GBP/USD exchange rate.

"I search for a hedge against substantial changes in the GBP/USD exchange rate."

So sell GBP.

If you want to be picky, and accommodate the stock movement, then adjust the fx hedge over time.

Yes, you could play with options, but all options trades are volatility trades. I didn't think you wanted to take on that dimension of risk, in addition.

 

[Rationalize]

Quote from RPEX:


...
1. Really you need to specify your account structure - when you purchased the stock did the broker/member automatically do the conversion selling your USD base and purchasing the necessary GBP before entering you into the stock trade. I only mention this because i know that IB would basically create a line of credit in GBP and wait for you to manually offset it - without offsetting it your FX risk would be covered and you would pay the financing cost instead.
...
*I might be wrong, please correct.

The fx risk is not covered on the line of credit. You pay the funding because they have lent you the foreign cash, but you're still on the hook for the fx movement on that loaned amount.

 

[RPEX]

Quote from Rationalize:

The fx risk is not covered on the line of credit. You pay the funding because they have lent you the foreign cash, but you're still on the hook for the fx movement on that loaned amount.

I can only talk from my own experiences and i spent a while getting an IB representative to confirm it, but it might still be wrong. Also it could be totally irrelevant to other brokerages.

Basically if you have a universal reg-T account at IB the base currency is the reporting currency and that's how i will measure my account performance. If i buy a stock which settles in a foreign currency, and i don't currently hold that currency in my account, then a loan is automatically created which is secured by the deposited base currency.

Assume i am flat everything else,
and we assume the stock price doesn't move,
ignore transactions costs (if commissions are in foreign currency)

Scenario 1> the foreign currency strengthens vs my base currency. Then the value of my stock holding (in terms of the account base currency, because that's how i measure my performance) increases. However this increase is offset by an equal and opposite change in the value of my liability in terms of my base currency. That is i gain from the stock because its worth more in terms of my reporting clams, and i lose because to pay off the loan will take more of my reporting clams.

Scenario 2> foreign currency depreciates vs my base currency.
The value of the stock holding in terms of my reporting clams is lower. This is offset by the gain from my liabilities shrinking relative to my reporting clams.

For the privilege i pay IB LIBOR+many bp clams for the foreign clam loan.

Please poke a massive hole in that. Obviously stock prices do move and when everything is squared off, there will likely be a net exchange position. Red face if i'm wrong.

 

[Rationalize]

Sounds like IB is taking on the currency risk for you, the charging you the carry cost on their hedge.

 

[RPEX]

Quote from Rationalize:

Sounds like IB is taking on the currency risk for you, the charging you the carry cost on their hedge.

Well they'll have offsetting balances from other customers with different base currencies, not to mention all the customers that trade through IBfx. In reality i think they'll have deposits in all of these currencies since they operate in those countries, so they're earning LIBOR+ on those balances which is more than they would get from the regular depo market - its a captive audience. In any case its nothing for them to hedge their exposure in the institutional market, where i may only be looking at a $10k clip.

 

[dazzwater]

What you want to do is lock down the GBPUSD exchange rate. So purchase a FX forward contract with strike price equal to the present GBPUSD rate, and expiry date equal to the timeframe in which you wish your GBP stock position to be hedged, and contract size equal to the GBP value of your stock position. This way, when the hedge expires your GBP exposure is exactly the same as when you entered the stock position.

Or if you want your hedge size to be adjusted for changes in your stock value, you can do what Rationalize said, and adjust the hedge contract over time.

This is a textbook answer, obviously. but it's efficient and I don't see why it can't satisfy your simple requirement.

 

[lightrader]

Thanks for all the responses.

So far the alternative of investing in the stock through IB's loan seems to be the most effective hedge, since I will only be exposed to the stock risk and not to the FX risk (but I will also incur substantiall financing costs).

All other solutions, such as selling GBP/USD's futures or just selling GBP do not completely eliminate the FX risk, since if the stock goes substantially down and the GBP/USD goes substantially up then I get a hit from both sides (the stock risk and the FX risk) -- and such situation cannot occur regarding the IB's loan mentioned above.

My understanding is that such "textbook" solutions of selling GBP or GBP/USD futures is most appropriate in trying to hedge the FX exsposure when you are directly long the underlying (actually holding GBP). However, in my case I am long the underlying only indirectly, and therefore such solutions may not really eliminate the FX risk (especially in cases that the stock collapes and the exchange rate goes substantially up, so that I will actually add an additional layer of FX risk to the stock risk).

If there is any solution that can be created by options or futures that would really eliminate the FX risk (similarly to the IB's loan, from which I prefer to avoid due to the financing costs) I would be glad to hear about it.

 

[RPEX]

Quote from lightrader:


My understanding is that such "textbook" solutions of selling GBP or GBP/USD futures is most appropriate in trying to hedge the FX exsposure when you are directly long the underlying (actually holding GBP). However, in my case I am long the underlying only indirectly, and therefore such solutions may not really eliminate the FX risk (especially in cases that the stock collapes and the exchange rate goes substantially up, so that I will actually add an additional layer of FX risk to the stock risk).

No there is no difference, selling GBP/USD IS an adequate hedge irrespective of the fact that you are holding the stock (you might have to adjust it slightly, not worth it unless a large amount). You can separate the FX risk from the risk of holding the asset, that's the point. But it only makes sense if the size of the hedge matches the amount of gbp to be hedged. You could try e-micro futures on cme which has a contract size of £6,250 and do it in increments. Of course in exchange for fx risk you take on basis risk, but i wouldn't worry about that. Also if you are holding for the long long term remember you will have to pay the roll on the futures hedge.

 

[atticus]

Quote from RPEX:

No there is no difference, selling GBP/USD IS an adequate hedge irrespective of the fact that you are holding the stock (you might have to adjust it slightly, not worth it unless a large amount). You can separate the FX risk from the risk of holding the asset, that's the point. But it only makes sense if the size of the hedge matches the amount of gbp to be hedged. You could try e-micro futures on cme which has a contract size of £6,250 and do it in increments. Of course in exchange for fx risk you take on basis risk, but i wouldn't worry about that. Also if you are holding for the long long term remember you will have to pay the roll on the futures hedge.

The swap is insignificant.

 

[lightrader]

Quote from RPEX:

No there is no difference, selling GBP/USD IS an adequate hedge irrespective of the fact that you are holding the stock (you might have to adjust it slightly, not worth it unless a large amount). You can separate the FX risk from the risk of holding the asset, that's the point.

Can you please elaborate on the adjustment issue? I really can't understand how you can separate the FX risk in this way when the stock collapses and the GBP/USD goes substantially up. In such situation I'm fine with losing on the stock itself but not with losing on the FX hedge in addition to losing on the stock.