Sales Trader
Summary: Investors trading in global equity markets are subjected to a wide variety of risks including company specific risk and market risk. However, a lesser-known risk facing investors as they invest in equities denominated in different currencies is FX risk. FX risk affects investors who buy equities in a different currency from their base currency (currency of their home country or where most of their income is based in) and this can impact their equity returns over time.
What happens to your equity returns when USDJPY moves?
Suppose you bought Fast Retailing at the market open on 13th April 2023. On 8th March 2024, your investment in Fast Retailing has done well, gaining 47.52%.
In the example above, due to USDJPY rising (JPY weakening) during the holding period, the overall return of the investment fell from 47.52% to 32.57% in USD terms. On the contrary, if USDJPY went down, then that would have meant a better return than 47.52%.
What Can Investors Do?
1. Do nothing.
If investors are consciously taking the FX exposure in the stock investment or have a view that USDJPY will go lower for their investment horizon, they can choose to do nothing and let the FX exposure prevail. Their overall return in USD terms will fluctuate based on the USDJPY rate.
2. Investor can hedge the FX exposure by trading FX spot or FX forward.
Investors can hedge the FX exposure by selling the equivalent of the JPY exposure in the Fast Retailing stock with the following steps below:
a) Calculate the JPY exposure of the position. This is 2,944,000 JPY in the example above.
b) Sell 2,944,000 JPY against USD as an FX spot position.
c) P&L from this position is summarized in the table below. In USD terms, it is $2,240.88.
The P&L calculation above is a simplified one ignoring the effect of interest rate differential between USD and JPY which was also extremely favorable for the hedge in this case because of the sharp differencing interest rates between USD and JPY.
If investors want a precise hedge, then they can choose to do an FX forward for their expected duration of the investment upfront and roll it over to a further date when needed.
FX hedging impact on equity return in USD terms
If we examine the impact of equity returns from FX hedging, we see that this raises the return (%) in USD terms from 32.57% to 42.70%. It is still lower than the original stock returns of 47.52% as the FX hedging is only done at the beginning of the trade. To achieve the exact stock returns in USD terms, the investor would need to constantly FX hedge as the JPY exposure rises as Fast Retailing heads higher.
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Check out how FX risk affects your US holdings too via this case study on Microsoft stock.
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