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Forex: Hedging Gains
Forex trading can be a very effective way of locking in gains on overseas investments that have been generated by favourable changes in the exchange rate.
Consider the following example:
18 months ago an investor moves £5,000 into a US Dollar trading account at an exchange rate of 2.0000 and receives $10,000. The $10,000 is invested in some US stocks.
Today the investor’s US investments are still worth $10,000 however the exchange rate is now 1.4500. If the investor was to sell their US investments and transfer the money back to British Pounds, the $10,000 would be worth $£6,896, which is a currency gain of £1,896.
The investor doesn’t want to sell their US investments, but does want to lock in the currency gain as they think the Pound is going to rally against the Dollar.
The investor buys a $10,000 lot of GBPUSD (i.e. buys British Pounds and sells US Dollars) via a Forex trade. The money deposited to cover the Forex margin would currently generate income as the British Pound is paying out a higher level of interest than the US Dollar, but this can change over time.
If the exchange rate moves from 1.4500 to 2.0000 over the coming months, then the Forex trade will generate a profit, while the US investments worth in British pounds will fall in value; the net effect is that any gains on the Forex trade offset the currency losses on the US investments.
Vice versa, if the exchange rate falls, then the Forex trade will loss money, while the US investments increase in value. The investor is therefore hedged at an exchange rate of 1.4500 regardless of which way the currency moves; makes for a better nights sleep.
When creating a Forex hedge against over seas investments, the objective is to take a Forex position that will generate an equal and opposite gain or loss to the overseas investment worth in British Pounds.
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