FX Optimal Hedge Ratios
I asked this on the IB forum, but this seems to be a better place for the question, I was wondering how companies calculate how much of their foreign currency exposure to hedge against currency rate changes (with forward contracts) so that they get the best balance of low risk and low carry cost (price of contracts). Any insight into this would really help me a lot. This is in the case a corporation has a long outreach and has exposure to many different currencies, some volatile and some not.
Thanks!
Companies are generally extremely risk intolerant with FX. They're not hedge funds - the margins are made from delivering products and services, not taking risks on the markets.
I used to hedge with forwards if the VaR was greater than the cost of the forward. Simple and quick to calculate.
What I'd do is group all of your FX transactions into currency groups and work out the VaR on them. You'll probably find that most of them warrant being hedged. Possibly stronger currencies won't need to be but as I said earlier, most companies prefer to take a small hit to their margin through a forward than risk eroding it entirely through a adverse market move.
If you have diverse enough currency exposure you may find that you're naturally hedged anyway though.
Hey thanks for the reply. I have a financial model given to me by our investment bank and I played around with it and found the lowest possible risk for the lowest price. However the model does not take VaR into account and I will try calculating it. Basically you hedge just enough for the VaR to be greater than the cost of the forward is what you are saying?
Thanks again
Yes exactly. If you have a £100 transaction and the VaR is £5 then it makes sense to take out a £4 forward. If the forward were to cost £6 then it's not worth it (in theory). Depending on your/the companies risk appetite you may want to hedge anyway though.
In practice this is pretty tricky if you have 100's of transactions in different currencies with different time horizons (when the company is going to receive the currency. I'm sure you'll work something out :)
The banks model may be smarter than what I'm suggesting. Mine is more of a quick and dirty tip.
thank you! Just one quick question though, what is PS? And as for our bank their model does not do any calculations for us. It just lays out our current exposure.
Sorry for the basic questions, I'm just an intern.
This website automatically converts the pound sign to PS for some reason. I guess it stands for pound sterling.
Can't they only hedge out short-term risks and not long-term risks? No expert on this, but if they have operations/sales etc in a country they are not hedging out 10-15 years of currency...i'm guessing 1-2 years max.
so it basically smooths out quarterly earnings, but does nothing to change the actual long-term value of operations.
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