If professional investors want to protect themselves from exchange rate fluctuations, they conclude futures transactions. They are cheap and only require a small amount of capital. Private investors can also use such contracts. There are a variety of different currency forwards available. They are designed differently in detail, but all work according to the same basic principle: In a forward exchange transaction, two parties agree to exchange two currencies at a predetermined rate at a predetermined time in the future. When the transaction is concluded, only a small part of the agreed amount has to be deposited as security, the so-called margin. The full amount is not paid until the contract matures (if the futures contract is held for that time). This results in the leverage effect of futures transactions.
If you want to hedge an equity investment in the USA against exchange rate risks, as a euro investor you have to sell US dollars in advance. The investor agrees with his broker to exchange US dollars for euros in three months, for example, at today’s exchange rate. Such a short position implies borrowing in the foreign currency. Because if there were no futures contracts, investors would have to hedge their shares with today’s exchange rate, take out a loan in the amount of the investment amount in US dollars and exchange the money immediately for euros.
The interest difference between the domestic and foreign currency corresponds to the hedging costs
The euros in turn can be invested in a secure interest rate investment for the term of the loan. The hedging costs that arise then result from the difference between the cost of borrowing and the income from the investment, i.e. from the difference between foreign and domestic interest. This interest rate difference is added to the respective daily exchange rate (spot rate), which results in the forward rate. If the forward rate is cheaper than the spot rate, it would be considered a banking jargon discount. The interest rate at domestic level is higher than at home. In the other example, when the advance rate is over the spot rate, buyers are paid a “premium.” Attractions overseas are larger. The disparity between interest rates in two areas of currency can be calculated from the so-called “bank and broker swap rate.”
Foreign exchange forwards are individually negotiated currency futures transactions between two parties, for example between an investment fund that wants to hedge exchange rate risks and a bank. The advantage: the contracts can be tailored precisely to the needs of a customer. Forwards are the most widely used type of contract worldwide. These are over-the-counter foreign exchange transactions, so-called over-the-counter or OTC transactions for short.
On the other hand, currency futures are structured trade contracts. Three, six and twelve months are common terms. Chicago Mercantile Exchange (CME), with branches in all major international financial centres is the world’s biggest trade centre for foreign exchange transactions. Because of the standardization of contracts, the transaction costs of foreign exchange futures are relatively low. They are the cheapest way to hedge against exchange rate fluctuations.
In contrast to futures and forwards, which require a physical exchange of the respective currencies on the due date, the buyer of a warrant only acquires the right to buy a currency at a predetermined rate during the term (or at a certain point in time) (call) or for sale (put). The buyer is free to exercise the option or to let it lapse. The seller of the warrant receives the option price as a premium from the buyer. A warrant is a type of risk insurance, the price of which rises as the volatility of the underlying asset increases. Quotes are determined by a number of other factors. And the lever also fluctuates over time. If you want to use and trade warrants successfully, you have to deal intensively with how these papers work. That is why they are hardly an option for the majority of private investors. More about warrants and options.
An alternative to warrants are leverage certificates. They have the advantage that they represent the development of a currency almost 1: 1. Because of the leverage, investors who use these certificates for hedging only have to raise a fraction of the investment amount to be protected. The main disadvantage of these products is their so-called knockout threshold. If the base value falls below or exceeds a certain mark, the certificate is either almost worthless or only a residual value is refunded, which the issuer determines “at its own discretion” depending on the configuration of the paper, as stated in an information brochure from Deutsche Bank. A leverage certificate is ultimately a risky bet on an underlying asset and is therefore not suitable for hedging exchange rates. More about certificates.
Better no currency hedging than overpriced products
Exchange rate hedging can reduce the risk of foreign investments . When investing abroad, investors should first check how the investment correlates with the currency. If there is no correlation ( correlation = close to zero), 100 percent hedging is optimal, the costs of which are reduced to the respective interest rate difference. The best instruments to protect against exchange rate risks are forwards and futures. Those who do not have access to these contracts can rely on funds whose currency risk is hedged by management.