In recent weeks we have seen how the eur/usd ratio is getting closer to parity. Right now, the euro is trading at 1.0562 dollarswhile at the beginning of the year it was at 1.1373 dollars, which represents a drop of just over 7%.
The most surprising of all is that a year ago the relationship eur/usd moved close to 1.22 dollars. The dollar is eating ground to the euroThe monetary policy of the Federal Reserve of raising rates against the ECB’s policy of continuing at 0% rates justify the growing demand for dollars and, consequently, their appreciation against the euro.
The problem with this devaluation is that assets listed in dollars become more expensive and in a context of rising raw materials, currency risk and price risk turn against the Eurozone when it has to sue the United States.
US exporters whose prices are fixed in euros and receive payment in a few monthsa fall in the euro harms them, since the total amount of dollars received decreases.
Investors whose base currency is the dollar and are invested in European stocks, the same thing happens: they need to manage the currency risk so that the devaluation does not negatively impact the net asset value of their portfolio. This not only happens with the amount of the portfolio but also with the expected flows via dividends, a flow denominated in a foreign currency at a future date.
Manage currency risk with futures
If we want to manage currency risk, we have to approach the financial derivatives market. Currency futures are one of the main methods of hedging against the volatility of exchange ratessince they avoid the impact of currency fluctuations during the period covered by the contract.
investors use futures contracts to hedge against currency risk. If an investor is to receive a cash flow denominated in a foreign currency at a future date, he can lock in the current exchange rate by entering into an offsetting currency futures position that expires on the date of the cash flow.
Currency futures are standardized contracts that are traded on centralized exchanges. Futures are cash-settled or physically delivered. Cash-settled futures are settled daily at market price.
As the daily price changes, the differences are settled in cash until the expiration date. For futures settled by physical delivery, on the expiration date, the currencies must be redeemed for the amount indicated by the size of the contract.
Currency futures contracts comprise several components that are described below:
First of all, we have the underlying asset. This is the currency exchange rate specified expiration date. For cash-settled futures, this is the last time it is settled. For physically delivered futures, this is the date the currencies are exchanged.
As we have said, the contracts are standardized, which means that the size is fixed. For example, a Euro FX contract (EUR/USD) is standardized at 125,000 euros.
Futures contracts are leveraged and with an initial margin we can attend high positions. A maintenance margin will also be set and if the initial margin falls below this point, the broker will require the margin to be replenished and, if not, the contract is closed.
Let’s see an example, to understand how this operation would work.
Let’s imagine that an American investor has 1,000,000 euros in assets in his portfolio. Given the expectation of a deterioration in the exchange rate, it intends to cover its position. In this case, the solution is given by adopting a selling position (going short) in the eur/usd contracts with the acquisition of 8 contracts (8 x 125,000 euros = 1,000,000 euros).
If, for example, the evolution of the exchange rate goes from 1.06 dollars to the parity between both currencies, the calculation would be as follows: (1.06 – 1) x 8 contracts x 125,000 euros of nominal value = +60,000 dollars.
In this way, it would be possible to mitigate the consequences of the fluctuations of the eur/usd pair on the net asset value. What we lose in the portfolio due to devaluation of the exchange rate, we gain with the sale of 8 futures contracts on the exchange rate.
In this case, the coverage is perfect because the total amount denominated in euros is a multiple of the standardized size of the contract, but many times this will not happen. For it, CME Group, the world’s largest financial derivatives exchangemakes smaller contracts available to investors.
In this case the E-micro EUR/USD is of a size of 12,500 euroswhich allows small investors or more specific investment positions to adjust the coverage.
Managing currency risk can be used for hedging operations, that is, to reduce risk, but also to increase the risk. Currency futures can also be used to speculate and, by taking a risk, try to profit from rising or falling exchange rates.