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cyrix


Total Posts: 8
Joined: Aug 2016
 
Posted: 2017-08-12 03:09
I am in the US and my base currency is the USD. I want to buy 100K Euro of a stock which is denominated in EUR and listed on a European stock exchange.
The way my broker (Interactive Brokers) performs the transaction is that it will automatically create margin loan in EUR for me to buy this stock. (https://ibkr.info/node/722)

My question is: am I subject to currency risks when I invest in this stock, and how can I hedge them?
My goal is to capture only the price growth of the stock but not the currency movements.

Initially I was planning to short 100K EUR/USD to hedge the FX risk, but when I thought more about it, it was probably not the right move.
Now I start to think there is only currency risk on the gain of the stock, because IB lends me the 100K in Euro when I buy the stock. When I sell the stock in the future, the funds will be returned in Euro, i.e. only currency risk on the gains.

Is that correct? If so, how can calculate the size of the hedge when I place the trade? How much EUR/USD should I go short to hedge this 100K EUR position?

Thanks.

GeekySerge


Total Posts: 42
Joined: Apr 2010
 
Posted: 2017-08-12 12:05
Some more info:
https://www.interactivebrokers.com/images/flash/tours/MechanicsOfForeignTransaction/index.html

cyrix


Total Posts: 8
Joined: Aug 2016
 
Posted: 2017-08-14 13:18
This is the same info as the link in my original post (https://ibkr.info/node/722), which leads to my question about hedging.

GeekySerge


Total Posts: 42
Joined: Apr 2010
 
Posted: 2017-08-15 03:10
> This is the same info as the link in my original post (https://ibkr.info/node/722)...

Not quite true. If the information contained in the video is the same as the one in your link you wouldn't have asked the first question present in your post and you wouldn't have made the simplified assumption of shorting 100k EURUSD to hedge the currency risk.

> The way my broker (Interactive Brokers) performs the transaction is that it will automatically create margin loan in EUR for me to buy this stock.

That's not the only option, you can either use a margin loan of EUR 100k or convert an equivalent amount of USD into EUR 100k and then buy the stock. In the first case you will pay an interest on the margin loan (linked also to the EUR base interest rate) for whom you pledge USD cash as collateral, in the second case you will pay the USD Fed Funds Overnight interest rate (plus some IB markup) on the amount (https://www.interactivebrokers.com/en/index.php?f=interest&p=schedule).

With the margin loan, as you correctly assume, you have currency risk only on the gain/loss of the stock (you still have to be fully aware of the margin call risk), in the other case instead you run fx risk on the full amount. The second case is what is called (in case of positive interest rate differential between the local and the foreign currencies) a carry trade or uncovered interest arbitrage which, in its purest form, is executed just on pair of currencies, i.e., without buying any stock/other asset. As you can see, the margin loan gives you already a big chunk of your fx hedge.

>...how can calculate the size of the hedge when I place the trade? How much EUR/USD should I go short to hedge this 100K EUR position?

For a simple static hedge check the recent CFA book Derivatives by Wendy L. Pirie, section "5.3. Managing the Risk of a Foreign-Market Asset Portfolio" (pag.415) and the Example 9 (pag.418) in particular: https://books.google.com/books?id=2l5zDgAAQBAJ&pg=PA415

If you want to know more check the following and the references therein:
- Callum Henderson, Currency Strategy: The Practitioner's Guide to Currency Investing, Hedging and Forecasting => Chapter 8
https://books.google.com/books?id=ZU3EIcvxUGgC&printsec=frontcover
- Fischer Black, Universal Hedging: Optimizing Currency Risk and Reward in International Equity Portfolios
https://www.jstor.org/stable/4479236
- Helen Guo, Laura Ryan (PIMCO), Currency Hedging Optimization for Multi‚ÄĎAsset Portfolios
https://www.pimco.com/en-us/insights/viewpoints/quantitative-research-and-analytics/currency-hedging-optimization-for-multi-asset-portfolios

cyrix


Total Posts: 8
Joined: Aug 2016
 
Posted: 2017-08-15 03:39
Thank you.

TakeItAndRun


Total Posts: 90
Joined: Apr 2010
 
Posted: 2017-08-16 11:15
In a nutshell, to avoid IB margin on interest rate:

Buy 100000 EUR/USD (using FX Convert) @ 1.1750
Buy 458 MC SBF @ 218 (assuming the purchase of 100kEUR of LMVH)
Sell 1 Future EUR Sep18 17 Globex @ 1.1770
Roll the future if needed

Since the future multiplier is 125000, the fx position is over hedged by 25%.

If LVMH price increases by 87% one may sell one more future contract
if LVMH price decresses by 37% one may buy the future contract

The maximum EUR amount which might not be hedged is equal 62500 (0.5 future).

day1pnl


Total Posts: 1
Joined: Jun 2017
 
Posted: 2017-08-16 17:43
Yes, you will have currency risk.
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