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Hedging Currency Risk: 4 Options for the Plummeting Dollar
November 9, 2009
With the United States Dollar threatening or at new lows against the Australian Dollar, Euro, Canadian Dollar and Japanese Yen today, dollar denominated trading system and CTA investors are wondering just what they can do?
The main issue the US Dollar is facing is the huge amount of debt the US has taken on to save the world from the financial crisis, and the Fed’s current stance that it will keep interest rates effectively at zero for the foreseeable future. When contrasted with Australia, which recently raised their interest rate for the second straight month to 3.5%, you can see why the US Dollar is down about -35% against the Aussie Dollar in the past 8 months. Would you rather earn 3.5% on your money, or 0%?
Everyone who would rather earn 3.5% are involved in the so called ‘carry trade’, where you borrow US Dollars at a low rate, and purchase Aussie Dollars (for example) with the borrowed money, then make the spread between the rate you borrowed at and the rate you are earning interest at.
As can be seen in the chart below, this renewal of the carry trade (it fueled in part the previous bubble when hedge funds and others borrowed Japanese Yen at a rate close to zero and earned returns elsewhere), has led to a sharp selloff in the US Dollar over so called riskier currencies since the March 9th stock market low.
Past Performance is Not Neccessarily Indicative of Future Results.
While we’re not in the business of forecasting where the US Dollar will go from here, we are in the business of helping our readers consider solutions for the very real possibility that the US Dollar keeps falling.
The bear market for the US Dollar could continue for quite some time given the record levels of debt the United States keeps issuing to finance its ever-widening account deficit. In the simplest terms, the United States government spends much more money than it takes in - by trillions of dollars - and must borrow money through issuing T-Bills and other government bonds. The more money the US borrows, the amount of money needed to cover those loans increases, and therefore the supply of dollars increases. As in any commodity, the more supply you have, the lower the demand and therefore the lower the price.
Added to this basic economic perspective is the feeling that a weaker US dollar could help erase the deficit that has caused it, putting even more downward pressure on the US Dollar. The logic behind a weak dollar helping reduce the deficit goes something like this: the weaker the dollar, the cheaper US goods are, and therefore the more US goods US citizens and the rest of the world buys, and therefore the US has more money than it spends, meaning it doesn't have to borrow as much. A weaker dollar also makes it easier to pay back our record $15 Trillion in debt, as the debt becomes worth less and less in real terms the weaker the dollar becomes. The relatively weak stance by the Obama administration regarding the dollar has signaled to many currency traders that a weak dollar is part of the administration's plan to cut the deficit.
Most investors shrug this off as insignificant to their portfolios, but the effect for foreign investors can be severe. To truly grasp what we are talking about here, imagine an Australian investor who opened an account in US Dollars in January of 2003. This investor would have had to convert about 178,000 Australian Dollars into $100,000 Dollars at that time. If this investor had exactly $100,000 Dollars left in the account today, and wished to convert her Dollars back into Aussie Dollars, she would have only about 108,000 Aussie Dollars left. Without doing a thing, this investor would have lost 70,000 Aussie Dollars. This loss would be on top of any potential losses or gains a specific alternative investment our fictional investor is weighing - and must be considered as a hurdle rate or break-even point for such an investment.
Some Silver Linings:
There is a flip side to the rise in the Aussie Dollar, Canadian Dollar, Euro and other currencies, however; and that is that it puts dollar based managed futures programs on sale, in a way. If it cost our Aussie investor in the example above 178,000 Aussie Dollars to invest in a $100,000 US Dollar minimum program a few years ago, that same investment is now 70,000 less. The fall in the US Dollar makes US produced goods like airplanes and elevators less expensive for foreign buyers, and makes that hotel room in New York 30% less than what it was 6 months ago; but it also puts managed futures investments on sale.
Here’s some more good news from an unexpected source. For non-US investors who are down US Dollars in their managed futures portfolio this year, those losses are worth a lot less in your native currency. Consider an investor in Clarke Capital’s Global Basic program, which is in the midst of a -30% down year after gains of just under 80% in 2008. An investor putting in the minimum of $50,000 on the first of the year is currently looking at a loss of about -$15,000. (Past performance is not necessarily indicative of future results)
Now consider that investor is from Australia. That -$15,000 loss would have been the equivalent of about -24,000 Aussie Dollars at the beginning of the year – but is currently only -16,000 Aussie Dollars. When your holding negative US dollars, you are in essence short the US Dollar; so there’s a little silver lining for anyone who has seen losses in US dollars this year.
What are some solutions?
The crux of the problem is that most investments worth making are in US $. This is especially true in commodity futures, and even more so in trading system and managed futures investments, which are invariably run on US $ denominated derivatives. The grand majority of futures markets are traded on US exchanges such as the Chicago Board of Trade and Chicago Mercantile Exchange. So what is an investor to do?
At Attain Capital, where a large portion of our clients are outside of the US, sophisticated investors have been implementing several of the techniques below to guard against further moves in the Euro and other foreign currencies.
1. The cash balance of your account can be held in a non-US investor's native currency, converting to dollars when needed to cover closed trades. The cash balance of the account would remain in the designated foreign currency, Euros for example, but if a trade was done in the S&P futures, for instance, resulting in a loss of $2,000 US Dollars, the amount of Euros needed to convert to $2,000 US Dollars at the current exchange rate would be converted. This method keeps the account in unison with the current exchange rate.
2. Investors can buy outright futures contracts on their native currency, gaining or losing the appropriate amount of money as the contract moves up or down. After all, this is what futures markets are designed to do. The problem inherent in that is you are locking in the current rate, as the account will grow as your dollars become less valuable and shrink as your dollars become more valuable. Many investors are leery of locking in such high rates, but this is what hedging is – locking in a current rate to protect against an unknown future rate. In addition, with no fractional contracts available, the investor must hedge as closely as possible with an appropriate round number of contracts. If having to round down to less than a perfect hedge, this would mean hedging profits less than those needed to offset rate losses, and if having to round up to more than a perfect hedge, this would possible hedging losses not equal to rate gains. This method attempts to lock in a specific exchange rate.
3. Investors can sell puts below or at the current market price of their desired foreign currency. You will keep the premium if the foreign currency goes higher, but this premium won't completely offset the loss in value of your dollars. If Euros, for example, head lower, you will be exercised on your option, taking a long position at the strike price. (Essentially locking in a lower exchange rate than in option 2) The benefit of this is you lock in a lower rate, and you keep the premium. The risk is that your currency heads higher and you only offset some of the losses. This method attempts to lock in a lower exchange rate.
4. You can overweight your native currency in your current trading, going long extra contracts when long term trend following systems give a long signal, and not taking the short contracts, as you are in essence already making money on the short side because of the conversion. This method attempts to "play" the exchange rate, locking in rates before it moves higher, and putting money back at risk when rates move lower.
Attain Capital suggests different approaches depending on the situation. For those investors opening new accounts, Option 1 may make the most sense if they believe their native currency will continue to outpace the US Dollar.
For those investors currently holding accounts in US Dollars, Attain Capital recommends a combination of Options 3 & 4. Trading systems are built to capture such moves in commodities and currencies, after all, and using a system for this purpose logically fits. Passing on short signals from a trading system in your native currency also makes sense, as holding your account in US Dollars gives you a synthetic short position already. Adding a short position from a system greatly increases the currency risk a US Dollar based investor has already taken on.
If you are a US investor who doesn’t like the sound of your assets losing value relative to the rest of the world, we also have several US clients who convert a portion of their accounts to a foreign currency (usually the Euro or the Aussie Dollar). Why not hold 25% of their account in Euros, they say; and another 10% in Aussie Dollars or something else. Similar to how Coca Cola and Proctor and Gamble diversify their profits by earning them all over the world in different currencies; you can have a blended portfolio of currencies in your managed futures account which could be a bit more stable than having all your money in a single currency.
Please call Attain Capital at (800) 311-1145 or email firstname.lastname@example.org for a review of your currency exposure risk and what options may be available to you.
- Jeff Eizenberg
IMPORTANT RISK DISCLOSURE
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Activity in most sectors of commodity and index futures was mixed during the past week, although another round of supportive economic signs and a surprise apparent takeover of a large transportation company kept optimism running strong. The past week also saw 3 central banks leave key lending rates unchanged with hints that low rates would be the norm in the foreseeable future. European news was a bit concerning as the Bank of England had to give 2 major banks more stimulus 1 of which reported a quarterly loss of $3 billion. Asian headlines continued as a market supporting factor with more news of strong imports of raw materials in several countries sparking ideas of increased investment demand. The lineup of economic reports this week is moderate with a mixture of economic, manufacturing and housing figures to be released. Stock Index futures were fairly active during the past week posting strong reversals after 2 weeks in a corrective phase with the tech heavy NASDAQ futures +3.86% leading the way followed by Dow Futures +3.25%, Mid-Cap 400 futures +3.24%, S&P 500 futures +3.21% and Russell 2000 futures +2.88%.
The metals complex ended the week higher with industry reports pointing to strong demand and news that Asian growth remained on firm ground continued to support price performance. Investors remain fixated on the metals not only as an inflation hedge, but also a hard asset play with growth seen better than earlier anticipated in emerging economies. For the week Silver +7.54% led the way followed by Gold +5.86%, Palladium +3.19%, Platinum +1.42% and Copper +0.41%.
Currency activity during the past week again saw the U.S. Dollar Index -0.69% lose ground to the majors on with strong metal prices and slow growth in the U.S. as the main catalysts. The market sector was also volatile due to all of the Central Bank announcements that in the end really were not all that surprising. The Swiss Franc +1.39% led the majors higher followed by the British Pound +0.95%, Euro +0.69% and Japanese Yen. The rate sector again was pressured from heavy offerings and lackluster demand with 30-year Bond futures ending -1.59% followed by 10-year Note futures -0.05%.
The energy sector was mixed during the past week as some supply and demand scenarios favored weakness in price activity, especially in Natural Gas -8.78% and RBOB Gasoline -1.51%. Crude Oil +0.84% and Heating Oil +0.23% were supported by tighter weekly supply figures and an uptick in demand heading into the winter heating season.
Commodity and Food products were mixed as weather issues continued to spark investor indecision in the grain complex, with ideas of a slower U.S. economic pace sparking pressure in the other sectors. Weather concerns again led to higher prices in the grains as the U.S. harvest of Corn remained way behind schedule as do wheat seeding in the SRW belt. Wheat +.61% led the way followed by Corn +0.27%. Soybeans -2.19% were pressured by lackluster sales and ideas that recent weather would not interfere with harvest potential. The livestock arena was lower as Lean Hogs -1.76% and Live Cattle -0.78% were under pressure from ideas that demand will weaken for the last 2 months of 2009. The Soft arena was weak from worries that slower economic conditions could put an end to fears of a supply rationing situation. Cocoa -3.37 felt the most pressure followed by Sugar -1.67% and Cotton -1.63%. Coffee 2.51% and OJ +.13% found support from Brazilian weather worries.
Once again, Option Trading Managers are starting November on the right foot. Range bound commodity and currency markets as well as declining VIX levels vs the last few days of October have been the driving factors thus far. Current estimates are as follows: ACE Investment Strategists +2.37%, Cervino Diversified Options +1.46%, Cervino Diversified 2x +3.01%, Crescent Bay PSI +1.60%, Crescent Bay BVP +4.55%, FCI OSS +1.17%, FCI CPP +0.84%, HB Capital +0.62%, Oak Investment Group +1.15%, and Raithel Investments +4.60%. In general 2009 has been an extraordinary year for many managers in this investment category and at the current pace several of the above managers are in the race for CTA of the year honors (if only they could erase 2008).
Specialty manager performance has been on and off for most of 2009 as many of the traditional fundamental market drivers Agriculture and Spread trading managers attempt to capitalize on have been adversely affected by the falling US Dollar. So far November is a slightly “ON” month with Emil Van Essen Spread Trading program leading the way with an estimated +0.72%. Emil Van Essen had a fantastic 1st quarter (+ aprox 15%) and has since steadied to remain +18.39% YTD. Agriculture traders are also slightly head with NDX Capital Abednego +0.03%, NDX Abednego Shadrach +0.48% and Rosetta flat thus far.
After a rough finish to October most multi market managers were looking forward to a new start in November. Market volatility spiked at the end of last month sending many managers into the red for the month. Conditions have calmed and trends are starting to re-emerge which should bode well for trend followers and other multi market trading strategies.
Thus far Hoffman Asset Management is the top performer this month with estimated returns of +1.17% with new trades in bonds and stock indexes. Right behind Hoffman and in second place is Mesirow Financial Commodities Absolute Return at +0.72% est. Mesirow has been taking advantage of trending market conditions in the precious metals. Other managers in the black include Robinson-Langley +0.53% est.,GT Capital Dynamic +0.29% est., Integrated Managed Futures Global Concentrated +0.17% est., and Sequential Capital Management +0.07% est.
Mesirow Financial Commodities Low Volatility and DMH are both at breakeven after one week of trading.
Elsewhere, some managers continued to struggle last week although we expect most will be able to bounce back before the end of the month. Managers in this group include Clarke Global Basic -0.11% est., Attain Portfolio Advisors Strategic Diversification -0.40% est., Futures Truth MS4 -0.72% est., Futures Truth SAM 101 -1.16% est., APA Modified -1.30% est., Dighton USA Aggressive Trading -1.75% est., Clarke Capital Global Magnum -1.90% est., Dominion Capital Management -1.97% est., and Quantum Leap Capital Management -2.24% est.
Finally, short term index trader Paskewitz Asset Management Contrarian 3X St. Index has had a good start to November at +0.99% est.
System performance was mixed last week with swing trading programs outperforming their day trading counterparts. Trading conditions were slow last week as market players were hesitant to dip their toes in the water ahead of the FOMC announcement and the jobs report on Friday.
Starting with the swing systems, Waugh Swing ES was the top performer last week up +$1,790 on a pair of closed out trades. Not far behind was Jaws US 400 which joined in on the selling in the 30 Year Bonds early in the week and closed out the trade for +$1,251.25 ahead of the FOMC announcement on Wednesday. Jaws US 60 had similar success early in the week but lost about half of what it previously made later in the week trying to jump back in on the sell side. Polaris ES bought into the rally in the Emini S&P early in the week and exited the trade on Wednesday for +$482.50. The Bounce systems are starting to show signs of life with positive results last week of +$380 for Bounce EMD and +$370 for Bounce ERL. AG Mechwarrior ES and Ultramini ES were just barely able to stay above break-even +$32.50 and +$15 respectively.
Swing systems unable to finish the week positive included Strategic ES -$615, Strategic SP -$3,125 and Bam 90 ES -$5,387.50.
Transitioning over to the day trading systems, results were mixed on fewer trades than the average week. Rayo Plus was one of the more active programs last week with three trades for +€620. BounceMOC EMD +$380 and BounceMOC ERL +$350 had almost identical results to their swing trading brethren on trades from Thursday. PSI! ERL rounded out the other day trading systems that were positive for the week with two trades totaling +$127.50.
Losing systems included BetaCon 4/1 ESX -€170, Waugh ERL -$470, Clipper ERL -$570, Compass SP -$925 and ATB TrendyBalance 2 Dax -€632.5.
IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.
Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.
The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.
Please read carefully the CFTC required disclaimer regarding hypothetical results below.
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.