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Currency Hedging

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Global Financing and Exchange Rate Mechanisms Paper 2

As more businesses become global the need for understanding foreign exchange and implementing hedging strategies could prove to be the one tool that may result in an increase or loss of investment. United States equity investors, international investing, or allocating assets to overseas stocks, is considered by most investment professionals as a legitimate way to strive for either higher returns or to lessen systematic risk in a diversified portfolio. It adds an asset class that is not perfectly correlated with U.S. equities (and if stock selection is effective) can provide excess returns. Returns on overseas investments include two elements: the stocks return in the local market and the impact on return when the local currency value gets translated back into dollars.

Over much of the post-war era, the U.S. Dollar was the primary reserve currency. This, however, is no longer the case. The U.S. Dollar itself can be the currency subject to deterioration in relative value; since September 11, 2001, this has occurred. The combination of a growing federal budget deficit, a trade deficit, declining equity markets, and low interest rates has eroded the strength of the U.S. Dollar. In cases where currency values are changing dramatically, the effect of the currency can radically alter total return results. Intuitively, this makes sense, of course. In the practical world, it is crystal clear.

Here is an example of the importance of hedging in managing risk. An investor decides to buy one share of a Japanese investment company, Yoka Taco, for 2,059 Yen (JPY) on January 17th. With the Japanese Yen trading at 1.68 to the dollar, the investor

Global Financing and Exchange Rate Mechanisms Paper 3

buys 2,059 Yen for U.S. $1,226 (2,059/1.68) to pay for the stock. In turn, the investor settles the trade in the local market and receives his share. On July 10th, he or she decides to sell the single share of Yoka Taco for 2,546 Japanese Yen. Seemingly, the investor has generated a 487 Yen profit (2,546-2,059), or 24%, on the stock. But now the buyer must repatriate the Yen into dollars. From January 17th to July 10th, the Yen decreased in value from 1.68 to 3.57 to the dollar. The investor repatriates the 2,546 Yens into dollars at the current rate of 3.57 Yens to the dollar and receives $713 (2,546/3.57). The investor now has gone from a 24% profit to a 42% loss because of the devaluation of the Japanese Yen. Had the investor hedged the currency risk, the profit would stand, less the cost of the hedge.

There is also the use in global financing operations as well, currency risk by contracting to sell foreign currency in the future, at the current exchange rate. Contracts are typically for periods of up to one year for U.S. Dollars. Should an investor sell the investment within the six-month period, he or she would already have guaranteed the exchange rate used for repatriation. Of course, the cost of doing a forward currency contract (as it is called) is primarily a function of interest rates. As one can imagine, the premium to cover the cost of carry for even a short period like six months can be expensive, when interest rate spreads are high, if a currency is being devalued. This is essentially the investor's cost. In this environment, hedging practices must be flexible.

Global Financing and Exchange Rate Mechanisms Paper 4

The value of forward contracts to buy U.S. Dollars diminishes if an associated foreign



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