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Investing with (FX) options: Hedging currency risk in USD-denominated portfolios using FX options
Koen Hoorelbeke
Investment and Options Strategist
Summary: In this insightful article, we explore the effective use of FX options as a strategy to hedge currency risk in USD-denominated portfolios. With a focus on the implications of a strengthening Euro against the Dollar, we provide a detailed example that demonstrates how investors can protect the value of their investments from adverse currency movements. It caters to both seasoned and novice investors, offering a clear understanding of how currency fluctuations can impact investment portfolios and how strategic hedging can mitigate these risks.
Hedging Currency Risk in USD-Denominated Portfolios Using FX Options
Introduction
Investors with portfolios largely consisting of USD-denominated stocks often face the risk of currency fluctuations, particularly the impact of a rising Euro against the Dollar. Protecting the portfolio's value from these fluctuations is a significant concern. This article presents a clear example of how FX options can be used as a hedge against such currency risks. It offers an objective look at the mechanics and outcomes of using FX options to maintain the value of a USD-heavy portfolio when the Euro appreciates.
Important note: the strategies and examples provided in this article are purely for educational purposes. They are intended to assist in shaping your thought process and should not be replicated or implemented without careful consideration. Every investor or trader must conduct their own due diligence and take into account their unique financial situation, risk tolerance, and investment objectives before making any decisions. Remember, investing in the stock market carries risk, and it's crucial to make informed decisions.
Complete Portfolio Hedging Example with FX Options
Context:
- Portfolio value to hedge: $100,000
- Objective: Hedge against the risk of the Euro appreciating to 1.15 against the Dollar.
FX Option Details:
- Current EUR/USD exchange rate: 1.0912
- Anticipated risk scenario: Euro appreciates to 1.15.
- Alternate scenario: Euro depreciates or remains unchanged.
- Call option specifics:
- Strike price: 1.11
- Option premium: 0.01455 per euro
- Nominal value of option: €100,000
- Expiration date: 19 June 2024 (166 days from now)
- Total premium paid: $1,455.00 (€1,379.00)
Hedging Strategy Execution:
- Purchasing the options: Buy call option(s) on EUR/USD with a total premium cost of $1,455.00 to cover €100,000.
- Scenario - Euro appreciates to 1.15:
- Without hedging: The $100,000 portfolio would be worth $100,000 / 1.15 = €86,956.52 in euros, a loss due to currency fluctuation.
- With hedging: Exercise the call options to buy €100,000 at the strike rate of 1.11, costing $111,000. When converting this amount back at 1.15, it's worth $115,000.
- Scenario - Euro depreciates or remains unchanged:
- Portfolio value: The value of your USD-denominated portfolio in euros increases or remains stable.
- Call options: The options expire worthless.
- Financial outcome: The loss is limited to the premium paid for the options, which is $1,455.00.
- Net gain and adjusting for premium (if Euro appreciates):
- Net gain from hedging: $4,000 (from $115,000 - $111,000).
- Adjusting for premium paid: The net gain reduced by the premium paid is $2,545.00 ($4,000 - $1,455.00).
- Net gain in euros: Converting the adjusted net gain to euros at the rate of 1.15, we have approximately €2,213.04.
Conclusion
Effectiveness of hedging: If the euro appreciates to 1.15, the strategy effectively mitigates the currency risk with a net gain of approximately €2,213.04, even after the cost of the premium.Cost of hedging: If the euro does not appreciate, the cost of the hedge is the premium paid ($1,455.00), which is the maximum loss in this scenario.
Overall financial outcome: This example demonstrates the potential outcomes of using FX options for currency risk hedging. It highlights the need to consider both potential gains in favorable market movements and the costs in less favorable scenarios.
Feedback? Ideas? Suggestions? Let us know.
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Previous "What are your options" articles:
- 21 Nov 2023: What are your options - Nvidia earnings
- 08 Nov 2023: What are your options - Disney earnings
- 26 Oct 2023: What are your options - Nasdaq Selling Premium
- 29 Aug 2023: What are your options - Salesforce earnings
- 25 Aug 2023: What are your options - the Qs - Nasdaq etf
- 23 Aug 2023: What are your options - Nvidia - earnings - market reactions
- 21 Aug 2023: What are your options - swing trading semi-conductors - stocks vs options
- 18 Aug 2023: What are your options - using TLT as an inverse proxy for the 10 year yield
Previous "Investing with options" articles:
- 30 Nov 2023: Investing with options - striking gold (GLD)
- 23 Nov 2023: Investing with options - hedging the Nasdaq 100
- 17 Nov 2023: Investing with options - Nvidia - pre-earnings
- 10 Nov 2023: Investing with options - AdYen - post investor day
- 31 Oct 2023: Investing with options - Novo Nordisk earnings
- 31 Oct 2023: Investing with options - Apple earnings
- 24 Oct 2023: Investing with options - Amazon earnings
- 24 Oct 2023: Investing with options - Meta Platforms earnings
- 23 Oct 2023: Investing with options - Alphabet earnings
- 20 Oct 2023: Investing with options - Microsoft earnings
- 18 Oct 2023: Investing with options - Tesla earnings
- 17 Oct 2023: Investing with options - long bonds - TLT
Options are complex, high-risk products and require knowledge, investment experience and, in many applications, high risk acceptance. We recommend that before you invest in options, you inform yourself well about the operation and risks. In Saxo Bank's Terms of Use you will find more information on this in the Important Information Options, Futures, Margin and Deficit Procedure. You can also consult the Essential Information Document of the option you want to invest in on Saxo Bank's website.
This article may or may not have been enriched with the support of advanced AI technology, including OpenAI's ChatGPT and/or other similar platforms. The initial setup, research and final proofing are done by the author.
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