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Newbie tasked with hedging currency risk of foreign investment
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Newbie tasked with hedging currency risk of foreign investment

  #1 (permalink)
Trading Apprentice
Los Angeles, CA
 
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Newbie tasked with hedging currency risk of foreign investment

Hi all, apologies in advance for the long post.

I work for a very small investment company (in the USA) that has agreed to fund a total of $2.5 million CAD investment in a Canadian project in unpredictable increments over the next 10-12 months. So $400k CAD may be called on March 12, then $70k in April, $1.1 mil in August, etc. with little advance notice. All of our company's available cash will be in USD at all points before capital is called.

My boss has asked me to figure out how to "hedge" against the risk of the CAD rising and thus making our investment more expensive in terms of USD. She cited a previous experience the company had where she had what she thought was a $1 million USD commitment turn into $1.3 million in the months the capital draws took place, and this strained the company's cash position at the time in a bad way.

I'm pretty fresh out of undergrad with a finance degree that I feel hasn't educated me fully on how to execute on this--not to mention no practical experience in foreign exchanges or derivatives trading. Additionally, the company doesn't do any trading whatsoever, so I'm going to have to pick a broker, etc.

My initial thought based on some early research is to buy 25 standard CME CAD/USD futures with a December 2016 expiration. Then we'd sell down the position proportionally as capital calls are triggered and we are forced to convert USD into CAD. So for example, if $300k CAD is required, we'll 1) sell 3 of our standard futures and 2) convert $___USD to $300k CAD. I'm hoping that this will lead to a net currency risk exposure of close to zero, after accounting for brokerage fees, etc. The hedge doesn't need to be 100% perfect but needs to at least eliminate ~80%-90% of this risk.

So my questions are--

- Does this plan make sense or am I way off the mark? If the latter, what should I be doing instead?

- What's the best way to go about picking a broker? Will it be difficult to set up? We would be using the account extremely infrequently.

- I estimated the margin requirement at ~$50k, is that way off the mark? I wasn't sure if I was understanding the materials correctly.

- Anything else I'm missing?

I read a lot of the introductory materials on this site and hope I'm posting in the right spot. If not, can someone please point me in the right direction? Thanks in advance for any help.

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  #2 (permalink)
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  #3 (permalink)
Market Wizard
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monomania View Post
Hi all, apologies in advance for the long post.

I work for a very small investment company (in the USA) that has agreed to fund a total of $2.5 million CAD investment in a Canadian project in unpredictable increments over the next 10-12 months. So $400k CAD may be called on March 12, then $70k in April, $1.1 mil in August, etc. with little advance notice. All of our company's available cash will be in USD at all points before capital is called.

My boss has asked me to figure out how to "hedge" against the risk of the CAD rising and thus making our investment more expensive in terms of USD. She cited a previous experience the company had where she had what she thought was a $1 million USD commitment turn into $1.3 million in the months the capital draws took place, and this strained the company's cash position at the time in a bad way.

I'm pretty fresh out of undergrad with a finance degree that I feel hasn't educated me fully on how to execute on this--not to mention no practical experience in foreign exchanges or derivatives trading. Additionally, the company doesn't do any trading whatsoever, so I'm going to have to pick a broker, etc.

My initial thought based on some early research is to buy 25 standard CME CAD/USD futures with a December 2016 expiration. Then we'd sell down the position proportionally as capital calls are triggered and we are forced to convert USD into CAD. So for example, if $300k CAD is required, we'll 1) sell 3 of our standard futures and 2) convert $___USD to $300k CAD. I'm hoping that this will lead to a net currency risk exposure of close to zero, after accounting for brokerage fees, etc. The hedge doesn't need to be 100% perfect but needs to at least eliminate ~80%-90% of this risk.

So my questions are--

- Does this plan make sense or am I way off the mark? If the latter, what should I be doing instead?

- What's the best way to go about picking a broker? Will it be difficult to set up? We would be using the account extremely infrequently.

- I estimated the margin requirement at ~$50k, is that way off the mark? I wasn't sure if I was understanding the materials correctly.

- Anything else I'm missing?

I read a lot of the introductory materials on this site and hope I'm posting in the right spot. If not, can someone please point me in the right direction? Thanks in advance for any help.

hi monomania, your best bet may be getting in touch with @Big Mike (the owner of this forum) - being this a trading forum geared towards speculation I'm not sure how many users can advice about hedging in the way you need it.

Mike likely knows most users and can perhaps point you in the right direction.

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  #4 (permalink)
Trading Apprentice
Los Angeles, CA
 
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xplorer View Post
hi monomania, your best bet may be getting in touch with @Big Mike (the owner of this forum) - being this a trading forum geared towards speculation I'm not sure how many users can advice about hedging in the way you need it.

Mike likely knows most users and can perhaps point you in the right direction.

Will do xplorer, thanks for the advice.

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  #5 (permalink)
Trading for Fun
Escondido
 
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Talk to a broker

Don't take anyone's advice at face value from a message board.

I suggest you interview a couple of commodity brokers to get their take on it. You're going to need to use a broker to do the transactions anyway.

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  #6 (permalink)
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monomania View Post
Hi all, apologies in advance for the long post.

I work for a very small investment company (in the USA) that has agreed to fund a total of $2.5 million CAD investment in a Canadian project in unpredictable increments over the next 10-12 months. So $400k CAD may be called on March 12, then $70k in April, $1.1 mil in August, etc. with little advance notice. All of our company's available cash will be in USD at all points before capital is called.

My boss has asked me to figure out how to "hedge" against the risk of the CAD rising and thus making our investment more expensive in terms of USD. She cited a previous experience the company had where she had what she thought was a $1 million USD commitment turn into $1.3 million in the months the capital draws took place, and this strained the company's cash position at the time in a bad way.

I'm pretty fresh out of undergrad with a finance degree that I feel hasn't educated me fully on how to execute on this--not to mention no practical experience in foreign exchanges or derivatives trading. Additionally, the company doesn't do any trading whatsoever, so I'm going to have to pick a broker, etc.

My initial thought based on some early research is to buy 25 standard CME CAD/USD futures with a December 2016 expiration. Then we'd sell down the position proportionally as capital calls are triggered and we are forced to convert USD into CAD. So for example, if $300k CAD is required, we'll 1) sell 3 of our standard futures and 2) convert $___USD to $300k CAD. I'm hoping that this will lead to a net currency risk exposure of close to zero, after accounting for brokerage fees, etc. The hedge doesn't need to be 100% perfect but needs to at least eliminate ~80%-90% of this risk.

So my questions are--

- Does this plan make sense or am I way off the mark? If the latter, what should I be doing instead?

- What's the best way to go about picking a broker? Will it be difficult to set up? We would be using the account extremely infrequently.

- I estimated the margin requirement at ~$50k, is that way off the mark? I wasn't sure if I was understanding the materials correctly.

- Anything else I'm missing?

I read a lot of the introductory materials on this site and hope I'm posting in the right spot. If not, can someone please point me in the right direction? Thanks in advance for any help.

With the fact that cash flows are that unpredictable it makes hedging a bit more complex than it could be. Normally businesses just use forwards since they are pretty straight-forward, and I like the fact that you are thinking of using futures, i.e. you can very quickly adjust your currency exposure, but there are two big considerations to consider, namely:
  1. You do not yet have a brokerage account. In my world, before we can open a new brokerage account, a lot of due diligence is required, i.e. comparing fees, assessing counterparty risk, etc. The actual opening of the account is a breeze, although if you need to do it for the first time, it can be quite a big task since you will need to get all the required KYC docs which may not always be that easy to obtain.
  2. Futures expose you to cash-flow risk. In essence, should the hedge move against you, you would need to make margin payments to maintain your hedge. Good news is that at least the CAD will be weakening in that case and your project will become cheaper, but if you are being squeezed for cash on your hedge, you may not be able to maintain the hedge.

With the information you provided, I would consider using forwards for the following reasons:
  1. Your current bank should be able to provide you with the ability to trade forwards. If they are able to place spot fx trades, they should be able to do forwards. Thus, you can use your existing relationships to place the hedge rather than needing to jump through all of the hoops to create a new brokerage account. This benefit alone is probably the deciding factor for me.
  2. Forwards are generally settled at maturity and generally require no margin payments. The bank may require that you have enough money in your account to cover unrealised losses, but it will be more flexible in providing financing than a futures broker will be should the need arise.
  3. Forwards allow you to tailor you hedges precisely (or at least in 10k increments). Futures have a fixed size and this may lead to some granularity although you mention that it does not matter too much.

You would manage the hedge exactly the same way as you described in your post above, except in this case, you would enter into offsetting forward contracts rather than close the futures position. You would then buy the required CAD in the spot market and transfer it out to meet your drawdown call.

Edit: Forgot to add that you should discuss the matter with your banker. They most likely already have a team that will be able to help with your specific situation.

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  #7 (permalink)
Trading for Fun
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Ask your bank to do it for you ..
normally ppl dont use futures for this kind of matter.

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