Musings on FX risk

Does an asset intrinsic risk/return profile change based on where I sit?

Let’s start with an example. I live In Switzerland with my best friend. He is a really good sports bettor and he generates rather stable returns out of this passion. We are good friends and he let me replicate his strategy so that I can earn some additional money too.

If you want to gain easy money too, he sells this cours…NO! It is just a hypothetical example, remember?

I have no interest in spending time in front of a laptop to place bets, so I gave my friend funds and now he places bets for the both of us. I use the gains to pay my rent in Zurich.

One day his girlfriend lands her dream job in Copenhagen and off they go. He plans to continue with his betting activity there because he can access the same online betting websites. I still need to pay rent so I leave my money with him: I do not think the change of scenery will affect his ability to bet. Still, now he is going to wire me DKK instead of CHF.

So I go to my landlord and tell him that from the next month, I am going to pay my rent in DKK; he is a multi-millionaire who does not really need my money and thinks he can gain bragging rights with his golf pals telling them he receives a fancy currency from a Kingdom. We peak at that day’s exchange rate and fix my new DKK rent. I use the same rate to convert the funds I give to my best friend.

Is my financial situation different?

My friend continues to generate gains as expected and I pay my rent as usual.

A couple of months later, my landlord calls me to tell me that actually, his golf pals told him he is an asshole. He doesn’t know what to do with my special King in the North money and wants that I revert back to pay my rent in CHF. My friend is still printing DKK with his betting prowess.

Is my financial situation different?

This cringy story is just to highlight how short-sighted is the standard way to assign an FX risk to an asset. I will buy this Italian bond because I live in Italy, fuck Treasuries. Ehm, they are not the same thing. Especially in your All Weather strategy for Italians (Ever tried pasta cooked by a German?).

It is as stupid as those headlines that say “Today, the US dollar depreciated 2%” or “A weak dollar caused …”. The US dollar can’t gain or lose value in a vacuum, a dollar is a dollar. It can gain or lose value in relation to another currency.

Similarly, the FX risk arises from a mismatch between assets and liabilities.

If I live in Switzerland but I always go grocery shopping in Italy, France, or Germany, and I fund those expenses with a portfolio of EUR bonds, I am fine (I am using this example because it is actually doable). When I was living in Geneva, I had some colleagues that were living in France and had a mortgage in EUR. Do you think they left their high Swiss salary for a job paying EUR? They went to a bank and hedged their bloody liability (I guess the bank forced them to, but the rate they got was surprisingly fair). They even acted with a certain dignity when the EUR/CHF rate dipped from 1.20 to 0.9 in a single day because…they understood what hedging means.

Liability Hedging in the Corporate World

Companies issue debt in a currency different from their functional one for many reasons:

• to lower their costs by offering their debt to a different group of investors eager to get paid less. We are having all these conversations around FX hedging because investors hate the FX risk. If I were a Swedish company, not many investors would buy my SEK-denominated debt because they do not want to figure out to hedge the risk. If I offer a USD-denominated bond, the pool of potential investors massively increases and, econ 1-0-1, my costs go down (ceteris paribus).
• to create a natural hedge. A US company that has a factory, an asset, in Germany can hedge that exposure by borrowing the same amount in EUR. Now the asset and the liability ‘move together’, their value goes up and down in relation to the EUR/USD FX rate in the same manner.
• to exploit particular market conditions. I would not ruin your day by explaining the concept of basis. Just know that sometimes arbitrage theories fail to work in the real world (for many valid reasons) and issuing a USD-denominated debt hedged into EUR results in a lower cost than issuing a plain vanilla EUR-denominated bond.

This is just to say that liability hedging is fairly common. Sure, companies often hedge their assets and revenues too. But to stress what I said above, a company that is based and listed in the UK, which happens to generate the greater part of its revenues in USD, is not going to hedge them, or worse renounce the opportunity simply because it would have an FX issue. They are simply going to use the USD as their functional currency. Even if all its bosses sit in London. Even if its shares are traded in GBP. See my previous post if this concept is not clear to you. In that case, the FX risk is on you, the investor who buys a share that is denominated in GBP and does not realize they have to hedge against USD.

Poor bastards

It is fairly easy to hedge an FX risk…if you have an ISDA. If you do not know what it is and how hard is to get one, The Big Short movie explains it well. Anyway, it is something that you and I will never have.

This is why liability hedging is not so common for retail investors. We are basically left with the natural hedge option, i.e. trying to adjust our costs in currencies that are represented in our assets (and not the other way around!). A lot of things are priced in USD: coffee, sugar and petrol are probably stuff that you consume regularly. The issue is that they represent just a small part of your liabilities.

Still, let’s dig a bit deeper.

The above chart shows how the CHF appreciated against a trade-weighted basket of currencies. The basket was built by the Swiss National Bank, so if you have an issue with it, take it with them. 60% of the basket is EUR, so if it is easier for you to picture it, imagine it is the EUR/CHF rate (upside down). The point is not this anyway.

Look at the distance between the blue line, the nominal exchange rate, and the red one, the real exchange rate. In short, that difference is simply explained by the difference in inflation between Switzerland and the basket. What does it mean?

Let’s use another example. Today wages in England are growing way faster than wages in Switzerland. Nominal wages, that’s it. England didn’t suddenly find a magical productivity source, salaries are growing so fast because inflation is (was, until last month) growing even faster. Without a compensating valve, the exchange rate between the pound and the franc, the lads would be able to buy all Verbier in a couple of years. It is like if Britain is printing those Zimbabwean dollars, sure within Britain you are free to YOLO your higher salary but outside, wait a minute.

Now back to our Swiss investor, who has assets invested in the same SNB basket (to make the comparison easier) and liabilities in CHF. Sure if he just looks at nominal stuff, he’s now crying about the fact that his assets are down a lot compared to a EUR investor (or what would have happened to his portfolio if he had hedged). What he forgets is that his liabilities also grew way less than the ones of the EUR investor, because of the low inflation in Switzerland.

The CHF appreciated c60% from 2000 to 2016 but 2/3 of that appreciation is explained by inflation dynamics. The Swiss investor’s real loss, the difference between the value of his assets and his liabilities, is just 30% of what he thinks he experienced. Turns out that not hedging the FX component was the real hedge.

“Wait a minute, but if he conventionally hedged, now he would be richer”

Sure dude, but that has to be framed as an active position, a trade if you want. The passive stance, the less risky one, has to be the 0-hedge. Why? Let’s move to Turkey then: you are a Turkish investor that diligently hedged all his FX risk. So in the last 10 years, your assets grew like the MSCI World Index in USD, 8.83% per year. Unfortunately, your liabilities grew like this:

Yep, that’s inflation in Turkey. Your assets grew and yet you are in a hole so deep that not even a charlatan performance would be able to get you out. If 10 years ago your assets were matching your liabilities, now they are almost half of it.

As I wrote in the past (for example here and here), the CPI index of the country where you live rarely represents your particular situation. Your liabilities can grow faster or slower compared to the CPI. The above examples want to highlight that what you think you are gaining/losing from an FX risk point of view might not be the full reality. More relevant, is that under some assumptions, not having FX hedges means to be asset-liability hedged and vice-versa.

Forward Points

There is another crucial aspect that we did not consider yet: the above examples assume that an investor can hedge their currency risk at the “spot” price, i.e. the exchange rate you see when you Google EURUSD. The spot price represents the rate at which an investor can, for example, sell X dollars for Y euros with settlement in two working days.

If a EUR investor wants to hedge a USD bond that is maturing in one year, the easier way to do it is to sell the same USD amount with a maturity of one year. The investor will take the USD he got back from the bond and give it to the bank he did the hedge with, so they end up with their desired currency, the EUR. If an investor wants to hedge an investment with no maturity, say a stock, they have to buy a hedge with a defined maturity and then “roll it” continuously. The rolling principle means that the investor has to close the existing hedge before it matures, buy USD if they were selling, and then open a new hedge with a longer maturity.

Honestly, it’s 20 years that I do this stuff and I realised I am not able to explain it anymore….

Let’s take it from another angle. Exchanging 1$ today for EUR comes with a different price than accepting to receive the same 1$ in one year’s time. This is because in that year you can do different things: you can decide to get the 1$ today and deposit it for a year, getting A% of interest, or you can deposit EUR for one year, getting B% of interest. A%, B% and the spot exchange rate are all known quantities today, so the difference in price between the spot rate and what is called the forward rate (spot rate + fwd points) is the price that makes the two choices equal for the investor:

What does it mean?

If A > B, then the fwd points will be negative; alternatively, if A < B, then the fwd points will be positive.

Let’s take our first example, an investor that has EUR assets and CHF liabilities. If they want to hedge their assets, they have to buy CHF and sell EUR at a certain future date. Since EUR rates are higher than CHF rates, they are selling EUR at a rate lower than spot, in other words worse for the investor. This means that our investor does not get the full benefit of the CHF appreciation shown in the graph but a bit less. That “bit less”, for a hedge that matures in one year, is close to the difference between EUR and CHF rates: if EUR rates are 3.75% and CHF 1.75%, the hedging activity costs 2%/year to the CHF investor.

The CHF investor that decides not to hedge their EUR assets has to see the EUR/CHF depreciate 2% before having a bigger loss than the CHF investor who decided to hedge.

The reverse is also valid. If TRY rates are 15% and USD rates 5%, a TRY investor that decides to hedge their USD asset will receive 10%/year return from the hedges alone. The TRY has to depreciate more than 10% against the USD before the TRY investor starts to lose compared to the unhedged proposition.

If you accept that exists a relationship between inflation and interest rates, you can understand how we arrived here. If you have liabilities in a low-yielding currency (EUR) and assets in a high yielding one (USD), hedging means locking a cost: since this is a form of insurance, the market more often than not moves the other way. This is what is normally known as the “carry strategy”, the fact that high-yielding currencies tend to appreciate, not depreciate, against lower-yielding ones.

Volatility

Volatility bites unhedged investors in two ways:

• the carry strategy is the best example of something that “goes up by the stairs and down by the elevator”; when carry strategies go wrong, they do it fast and big.
• sequence of return risk; if the investor withdraws funds from the portfolio, the currency mismatch between assets and liabilities can create additional paths or scenarios when the investor goes bankrupt.

But:

• carry strategies amplify stock drawdowns but not in a dramatic fashion, especially if investments are constrained to Developed Markets; the USD may even act as a fly to quality asset and reduce drawdowns (this is not always true).
• many investors worry about sequence of return risk even if they are years away from retirement (they are fine with stock volatility though).

Even during retirement, the sequence of return risk introduced by the FX asset and liability mismatch can be managed as the other sequence of return risk. For example, the investor can FX-match 5 years of liabilities and leave the rest unmatched.

Hidden Costs

I hope that this overview of some of the hidden costs / misconceptions over currency hedging of assets will help you to take a more informed decision in the future (I did not even cover all the intricacies related to FX hedging!). I think that the asset & liability framework is not an unnecessary complication but a more realistic way of looking at this matter.

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