Forum Archive Index - December 2001

[jesse <johne777@hotmail.com>]

Hi Marilyn & Viewpoint
I have been hedging my foreign currency funds (used for sharetrading)
for several years and can see how Sanford came to this result. Hedging
is a transaction using derivatives to protect a position in FX, interest
rates, commodities etc by using options, futures, forwards and so on. I
prefer forwards because they are cheap, efficient and simple to use and
understand. The objective is to transfer risk, away from yourself to
someone willing to accept it at the opposing end of the contract. Why do
they go wrong? Because there is a trade off between covering risk and
opportunity cost. I did the same as Sanford in 1999. I covered my $US
with a forward contract at .52 based on the so called experts predicting
a rising $NZ in the next 12 months to approx. .60 US cents.
(Incidentally, I sent my money to US when KIWI was higher so was sitting
on a gain). If I had left my funds exposed, I would lose tens of 000 of
$$. As it was, I lost the opportunity to gain tens of 000 of $$ as the
KIWI sank. But did I really lose money?  No. Say I covered $US 1M and
locked it in at .52 on a 2 year forward. 2 years later the KIWI is at 42
cents and my  $US is now worth 1m/.42 x .52 = $US1.238m, but I have to
settle with the bank and that is to the tune of $US .238. The whole idea
of the hedge is that you transfer risk away, but you forego the
opportunity to gain as well. I gained nothing, lost an opportunity. If
the KIWI had climbed, again I would have lost nothing and gained
nothing.  But, I could forget currencies and concentrate on shares.
But.....companies have to report to shareholders, including FX
losses...individuals don't. Just as well huh?

Unfortunately, there is no one correct way to handle FX risk. One reason
for this is competition. If every firm in an industry used the same risk
management techniques, eg, fully hedged or fully exposed,  then each
company would be competing only in it's area of expertise. But firms
take different approaches to FX risk. If Company A believes the KIWI
will climb in coming months, they may leave revenues exposed to FX risk.
This places pressure on Company B, because, if they fully hedge and the
KIWI does climb, company A gets a competitive advantage for it's
aggressive FX policy. So B is forced to an extent to keep tabs on A  and
not stray to far from a similar policy. Shareholders on the other hand,
want to invest in a firm because of the expertise it has in that area,
eg did you invest in Sanford because you thought it could grow the
business or because you thought the KIWI would fall? Hey, if people are
so good at predicting currency movements, why buy equities? You will
make 1000x more in currency if you pick right. But look at volatility
charts of currency v anything else over last 20 years.....nothing comes
close to currency fluctuations. Firms have to cover...but its a
specialist job and most firms just want to get on with running their
core business. If companies just kept rolling over hedge positions
perpetually, gains and losses would balance out in all probability,
unless their reporting currency was in death roll...(NZ?? haha) But most
will not do that, because there is an opportunity to gain from
currencies as well. At the end of the day though, you are either hedging
or speculating, so if you are a shareholder in a firm that continuously
looses money on FX, I would ask the question, is that where my money
should be?

Last bit......you were saying Viewpoint how its a zero sum
game.....true. But that is the objective...eliminate risk in an area you
are an expert in, and maximise gains in area of expertise. The classic
example  is the wheat farmer and the flour mill owner. It's 3 months out
from harvest and wheat is $7 a bushel. Farmer is worried that by
November, wheat price may drop to $5 pb. He takes a 3 month forward
contract on 100 tonne of wheat at $7 pb, which removes the risk of lower
prices but takes away the opportunity to get a higher price. At the
mill, the owner is worried the price of wheat could rise by November, so
he takes the other end of that contract, locking in the price so he
takes away the risk of paying more than $7pb, but gives up the
opportunity to buy at lower prices. Come November, doesn't matter if the
price is $5 pb or $50pb, parties settle at the agreed price of $7pb.
Zero sum, zero risk.
cheers
jesse


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