Forex Hedging – Dynamic Hedging
Traditionally, hedging your exposure to currency volatility is done by buying an options or spot contract. Each protects your downside for a cost.
Delta1Trader Technology provides a third – Dynamic Hedging.
Dynamic Hedging not only protects your downside, but also offers potential income against the underlying assets. In most cases, it tends to be the most cost limiting option as well. We offer hedging of various currencies, please contact us for further information.
OUR Performance – USDCAD Case Study
A client company had to hedge their exposure in USDCAD for an underlying credit transaction. We took a Dynamic approach to hedge the USDCAD with options and trade against the options portfolio.
The original cost to hedge USDCAD was about 5% of the face value of the exposure, using simple options positions. Meaning with an exposure of $3 000 000, the hedging cost would be $150 000.
We started using the Dynamic hedging model with our clients in June 2019. The performance as of the end of March 2020, was a net gain of $326 000 on a $3 000 000 hedge, a major income stream for an underlying cost.
In total, this client has made $476 000 in total net gain on the dynamic hedging model compared to a simple hedging strategy over the last 9 months. It makes a 15% total net return using this strategy vs. a traditional simple hedge. The increased market volatility in the start of 2020 created a very strong performance.
Model Cost and Framework
The benefits of Dynamic Hedging, as outlined, overwhelmingly offset the costs and risks associated with keeping the loan exposed to currency fluctuation risk. The natural follow up question is, what’s the cost?
One of the benefits of AI is that it eliminates a lot of the human administration needed to provide the service. Therefore, the overhead cost of running the operation is really only the brokerage fees on execution, and the price of the spot (roughly 1.5% of the face value of the exposure).
The team will help monitor the AIs and provide daily reporting to the client on any changes in risk. Profits that are capitalized on top of the hedged position will be paid out at the end of each month, with a 20% profit split for the life cycle of the hedge.
Hedging options – dynamic vs. simple hedging
#1 Buy an options contract
1 year put in USDCAD would currently cost around 5% of the face value of the risk exposure. It locks in the price, gives a 100% capital preservation and you end up with no risk.
#2 Buy a spot contract – The downside is fully protected
This strategy involves adjusting on the go, when there is any movement against you. This means you may have to add cash to the trading account. The cost of the contract is around 1.5% of the face-value of the risk exposure, plus potential additional cash on the trading account.
The total security (collateral/equity) needed is 10% of the face-value of the exposure. I.e. for $10 000 000 in exposure you would require $1 000 000 in cash.
This is collateral posting effectively serves as a deposit, which is returned at the end of the hedge.
# 3 Dynamic Hedge
This solution tends to be the most cost limiting. In addition to locking in the current price, it uses proprietary artificial intelligence models which are developed and integrated through the broker platform. There is a dedicated oversight committee who monitors the outlay and sends you daily updates on the exposure.
The models have the potential to provide income against the underlying loan, capital, products or investments. This can offset any costs you may bare through the year, such as interest.
Which option to choose?
1. Protect the bottom-line while providing potential for extra liquidity
2. These sophisticated models provide the borrower with the ability to lower their interest costs on the loan. This is done by capitalizing on any positive moves in the CAD, or movements against the USD.
3. In simple terms, if the CAD goes up in value, the models will signal to purchase. And if the CAD goes down the model goes flat and does nothing, since your underlying is already protected.
Risk disclosure: Trading Futures and Options on Futures involves substantial risk of loss and is not suitable for all investors. Opinions, market data, and recommendations are subject to change without notice. Past performance is not indicative of future results. We are a Swiss Asset Manager regulated by VQF. Our membership can be verified by searching for “Delta1trader” on the FINMA website.