International shares Hedged

[im sparticus]

can someone confirm, usually a hedge is a cost for the investor but lets say i invest my AUD in US stocks/fund then hedge my currency risk (or take up the hedged option with the fund) do i/the fund end up with a net credit on the ir diff for the hedge?

the most basic way i would see the currency hedge would just end up being a carry trade long aud short usd (hope thats the right way around)to the same value as the portfolio at purchase so all things being equal and currency being mean reverting over the long term the hedged portfolio has an edge over the unhedged portfolio being the ir diff?

most people tell you not to take up the hedged option and save on the hedging costs as long term yada yada yada, i just cant see where these costs are comming from when hedging your USD exposure.

 

[Aaron_C]

Hi sparticus,

The basic theory is best illustrated in numbers.

You buy a US stock portfolio worth US$100,000. In order to purchase this portfolio, you would be shorting the AUD and longing the USD.

To hedge against this currency risk, you would have to do the opposite trade, which would be longing the AUD and shorting the USD. This would involve longing/buying a futures/forward contract on the AUD/USD for US$100,000. The length of this futures contract depends on how long you intend to keep your US stock portfolio. This will be a complete currency hedge.

Let's just say for argument's sake your US stock portfolio increases by 7% in the first year. Because in your current hedging you are basically borrowing/shorting USD and buying AUD, you will pay interest on the USD borrowings and earn interest on the AUD holdings. Because USD borrowing rates are low and AUD interest-earning rates are higher, you will actually earn a little bit of interest on the AUD/USD trade.

So at the end of the term you will earn the 7% on your portfolio, PLUS the interest differential on the AUD/USD trade.

 

[im sparticus]

Thanks thats exactly what i was thinking now i just have to work out why financial advisors are telling me the hedged option costs more than the unhedged option maybe they keep the profits from the hedge for themselves and charge the fund an arbitrary figure for the hedge.
anywho it seems a no brainer to me why would i take on the currency risk if i could have it risk free and earn some for the privelage

 

[Aaron_C]

Well the risk you have is that your US stock portfolio actually loses money. But from a FX hedging point of view you should be covered fully.

Just note, however, that the bank will charge you a commission/fee for arranging a currency forward contract. The fee will vary but the factors are:

a) The longer the forward duration, the more expensive it will be.
b) The more amount of money you are purchasing, the cheaper it will in % terms.

I hope this helps and best of luck with it.