Forex risk, cost and how to hedge it explained
Main talking points of this article
This educational article covers a few topics surrounding the world of forex. It will help you understand the meaning of forex risk, how to hedge it, and the somewhat hidden cost of forex conversations.
Forex, or currency risk as it is also known, is when you deal with a second currency that is not your home currency. For example, if you live in London your home currency is GBP, and if you want to trade an American share, there is a certain amount of risk involved. When asking clients in the past, it was always surprising to hear that no real concern was given to FX risk.
Let’s assume you invested £10,000 at a rate of 1.5 GBP/USD = $15,000, in a random US share. Ten months later we are at a rate of 1.25 on the GBP/USD, if we convert $15,000 back into GBP we now get £12,000. We actually gained 20% if the share didn’t move at all, but we could easily have lost 20% on the currency rate.
It is important to always be aware of FX risk. When you invest in a foreign asset (anything that does not trade in your home currency) you could in theory double your money, if the exchange rate moves in your favour, and the US share goes up. However, if the USD depreciates you could also lose double. Always understand the risks and potential losses that can occur.
What do I mean with forex cost? Simply put, this is a fee for exchanging your home currency into foreign money. If you and your family go on holiday abroad, you will need to exchange your money at the bank, and will usually be charged a forex conversation fee.
For example, your boss sends you to the US for some meetings, you go to your bank and ask them to change £1,000 into USD, the bank gives you $1,240. One week later your boss tells you the trip is off, you go back to your bank and the exchange rate has not moved. You ask to change your $1,240 back into GBP, and you are given £970.
All things considered, the bank, or in trading terms the broker, does offer you a service and it is reasonable to be charged, as long as this charge is reasonable. Do not forget to consider these costs when calculating your overall profits.
Hedging currency exposure
This topic becomes more relevant the larger your portfolio becomes. Companies for example, have used forex hedging for decades to manage their currency risk. Hedging is a type of insurance within trading and is sometimes confused with hedge funds.
Let’s look at a real life example. You currently own a company that produces car parts, and get approached by BMW to make a component for one of its cars. You agree on a price of 1 million Euros (BMW is German, so they pay in Euros which is normal). The issue is they will only pay you in three months’ time once you have produced and delivered the parts. Currently the exchange rate is 0.85 EUR/GBP and as a car parts manufacture you want to lock in this price. As the exchange rate currently stands you would make £850k, but this number could easily change if the exchange rate fluctuates, and in three months’ time you could get more or less GBP.
If you hedge, then you cannot lose or gain from the exchange rate. In this case the worst case scenario is that the EURO gets weaker against the GBP over the next three months. So to hedge yourself against this risk, you take out a trade that speculates exactly that. If the Euro gains you will make more money from BMW and lose on the trade; if the Euro weakens you will make money on the trade but lose money on the BMW deal. You are more or less plus one million and minus one million at the same time.
Using Spread Betting
One of the biggest selling points of spread betting is its capital gains exemption on profits. Meaning you basically don’t pay tax, which is great but another important factor is that you can ignore forex risk and cost when trading on a spread betting account.
You are able to buy US shares for example in GBP per point. Without going into great details about how brokers operate behind the scenes but they basically hedge the forex risk for you and that also includes the cost.
To summarise if I buy normal US shares like Facebook with a stock broker, you have two variables, the share price of Facebook and the GBP/USD exchange rate. On top of that your bank or broker will also charge you for buying the shares and for the forex conversion cost.
This educational article should give you some additional knowledge on forex, in particular on forex risk, forex cost, currency hedging and how these can be avoided using a spread betting account. Other useful articles on forex include: “What is Forex and How do I Trade it?” and “Tom-next Explained”
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Financial Trading Explained
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