Hedging Portfolio with Currency Forward

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Galli

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This question is in relation to question 8 of reading 19 (page 80)
The question asks how simply matching a the current market value of the foreign-currency exposure with an equal offsetting position in a forward contract would expose the portfolio to currency risk.
I thought the answer would have stated that the forward contract will converge to the spot rate over time, therefore the portfolio will slowly become less hedged versus the intial position due to the nature of forward contracts.
However the answer says the portfolio value will move around over time and the portfolio manager will have to rebalance the portfolio in order for the hedge to be effective.
Is my logic wrong or just less right than the answer? I see what they mean about the portfolio gaining/losing value but that would be the case with all currency hedges, not just this specific example. Not sure if they’re just trying to point out the difficulties of a static hedge versus dynamic but it’s not entirely clear to me.
 
I think these are two different things and here you don’t need to bother about the fact that the forward contract will converge to the spot rate over time.
Let’s take an example where you know how much you will receive in foreign currency in one year. It’s a trade receivable. You know you will be paid 100 units of currency a. So you hedge this position with a forward giving you 120 dollars for 100 a in one year. In one year you receive 100 a and you exchange it against 120 dollars thnxs to your forward. If in the meantime, the value of your forward contract has evolved, maybe even 100a in now worth 130 dollars,but it makes no difference to you at the end: you knew from the beginning what you would get.
Here you hedge a portfolio and you don’t know how much it will be worth at the end of the period. So maybe you hedge 100a at the beginning. If it increases to 140 a you may want to buy some more forward contracts. If it goes back down to 110 a you may want to sell some… well rebalancing along the way.
Now what i am wondering is: what is “an equal offsetting position” at the beginning of the period you want to hedge? Is it 100a or is it your forecast value of the portfolio at the end of the period? If someboby could help us with that… thanks!
 
Fx Forward contract will not converge to the spot rate over time. The price has determined in trade date.
The answer saying if you hedge against the initial portfolio value, say 1m USD, if the final portfolio value is not 1m USD because of market movement, then it’s not fully hedged. (Forward position will still be equivalent to 1m USD)
 
FrankCFA wrote:
Fx Forward contract will not converge to the spot rate over time. The price has determined in trade date.
The answer saying if you hedge against the initial portfolio value, say 1m USD, if the final portfolio value is not 1m USD because of market movement, then it’s not fully hedged. (Forward position will still be equivalent to 1m USD)
Click to expand...
I see what you’re saying but I diagree with the converage comment.
I think my conclusion is to ignore spot rate changes and focus on the portfolio value change, which in theory captures the spot rate movement.
thanks for the help.
 
You guys are not talking about the same thing. This is why you don’t agree.
I think it is a matter of wording / definitions.

1) what we call forward price is the agreed upon price of an asset in the contract. So yes, as Frank says, it is set at contract trade date. It is not going to change.
2) But (and maybe this is what Galli has in mind) the forward price of a newly issued forward contract will converge to the spot rate over time.
For example, you issue a forward contract (#1) now at price x for delivery in one year. Then you issue another one (#2) 6 months later at price y for delivery in 6 months. Y will be closer to the spot price at the time of issuance than x was when it was issued.
But i think this is a bit out of topic here. Except maybe if you want to determine how the value of your hedge evolves. Ok, it is still a bit out of topic but we can have a look.
If you hedged using forward #1, (y-x) discounted gives you the value of your gain and loss on this instrument after 6 months. But it will exactly offset the gains or losses from the currency exposure that you wanted to hedge if you could hedge fully because future cash flows were known (see my receivable example).
After one year (at maturity) the value of your instrument is the difference between the spot rate and x, which as well, exactly offsets your fx gains or losses.
So again, this is getting too complicated here, you don’t need to bother about the change in value of your forward and the gains or losses from your foreign currency exposure if you are fully hedged. At the end it is (xx) -(xx)= 0 no matter what xx ended up being.
 
(I think I deserve a critical comment from Magician for complifying the simplicated side here. I was just trying to meet your thoughts. I hope I did not make it even more confusing)
 
You’re long 1 unit of USD/EUR (1 Euro) due for delivery in 90 days, that 1 unit would be +/- some sort of premium/discount to today’s spot euro-dollar rate. Overtime the 1unit (still 1-euro like Frank is saying) will converge toward the spot rate. You may, or may not, pay less dollars though.
Have I completely lost my mind?
 
myriam2222 wrote:
If you hedged using forward #1, (y-x) discounted gives you the value of your gain and loss on this instrument after 6 months. But it will exactly offset the gains or losses from the currency exposure that you wanted to hedge if you could hedge fully because future cash flows were known (see my receivable example).
After one year (at maturity) the value of your instrument is the difference between the spot rate and x, which as well, exactly offsets your fx gains or losses.
Click to expand...
yeah and that’s what I meant by the portfolio capturing the changing value of the currency.
 
If you bought a forward contract by which you will receive 1.25$ by paying 1€ in 90 days, and in 90 days the spot rate is finally 1.20$ per €, then your forward contract is worth 0.05$ at delivery (positive value). The value of your forward changes to capture the changing spot rate. But the value of your contract, which has been signed/locked, is not converging towards the spot rate
 
I think you should just reopen level 2 curriculum on the valuation of futures. It is fairly straightforward. Things will become clear to you right away.
 
I felt like we were saying the same thing but re-reading what I said it’s clear I wrote it wrong. It’s not the Forward rate that converges, it’s the spot rate that converages with the Forward rate.
This .05 converagance will also be realized in the portfolio value. Therefore (my original issue) is solved by knowing that the expected portfolio movement from FX will also be reflected in the original ‘hedge’.
 
Agree with myriam2222 here.
Value of your contract is not converging to spot price and you have accumulated 0.05$ of value.
 
Ok thanks Zulu
Galli, i am glad it is clear to you now.
So regarding currency forwards i think we are set.
Now, i was just studying commodity futures tonight. And I read something that is totally strange to me and maybe it is what confused you Galli. I will open a new post so that it doesn’t look like we are reopening a topic here.
 
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