Circumventing Foreign Currency Risk
not only generate profits, but must also minimize losses for its investors. In addition to the obvious losses due to the fall in share values of stocks held by the fund, losses can also be incurred by changes in FX rates. A prudent money manager can avoid FX losses by hedging via currency future contracts and options of the same. Hedging is similar to, what we commonly call, an insurance policy, in that it protects assets; in this case, the assets are foreign stocks and domestic stocks with foreign interests. For example, if a fund holds $1,000,000 of stock in a German company, denominated in Deuche Marks (DM), the fund would sell ten $100,000 DM commodity futures contracts on the Chicago Board of Trade (CBOT); if DMs remained stable by the time the fund sold the stock, the fund would neither lose nor gain on the futures transaction; if DMs, were to lose value versus the U.S. dollar during the stock holding period, the fund would profit on the futures contract and this would offset the currency losses incurred from the sale of the stock; if, on the other hand, DMs rose in value versus the U.S. dollar, the fund would experience a loss on the futures contract, which would, consequently, offset any profits due to currency inflation from the stock sale. Aggressive and knowledgeable fund managers utilize commodity futures markets, not only for hedging, but also as another profit center for the fund. For example, if the fund had sold twenty $100,000 DM contracts, instead of ten, in the above example, the fund would basically have two times the insurance it really needs; the additional $1,000,000 of coverage could be highly profitable to the fund. Profits from futures transactions could far surpass the profits from the actual stock transaction, and are often responsible for elevating the fund’s year-end yield standing well above those funds with the similar investment objectives that are not maximizing on FX opportunities.
Monitoring FX changes and relationships are paramount in ensuring the well-being of countries, profitability of companies, and positive yields for investors of foreign companies. Although governments have two effective methods (PPP & BOP) of evaluating and predicting the effect of changes in FX rates, governments do not have an effective way to protect their currency from appreciating or devaluating, but are at the mercy of large investors and fund managers that are constantly searching the globe for higher yields. Foreign companies, domestic companies with foreign interests, and investors, however, do not share the same fate. With today’s computers, Internet, access to information, and the ability to move capital globally, even the small investor can, not only, capitalize on foreign investment opportunities, but eliminate currency risks as well. Think global for higher yields!