Client:
European asset manager
Challenge:
Hedge exposure to the U.S. stock market and exchange rate risk
Solution:
Passive currency overlay
Overview
One of the most common uses for FX futures is hedging currency risk, also referred to as a currency overlay. Currency overlays are often used to address currency risk in an investment portfolio or scenarios where a commercial trading contract consists of two currencies. Strategies can be passive, active, or a combination of both with the overall intention of limiting losses and maximizing gains.
Approach
In this scenario, a European asset manager buys $500M worth of exposure to the S&P 500 (SPX) on February 28. As a result, they now have two risk positions:
- Exposure to the U.S. stock market (through SPX)
- Exposure to the USD/EUR exchange rate risk
In order to gain the $500M exposure, the asset manager would have to convert €472.77M at the prevailing spot rate of 1.0576 into the $500M to purchase the same risk equivalent in the S&P 500, which was at an index value of 3970.15.
The asset manager looks at the June futures expiration on the EUR/USD (6EM3) for the currency overlay.
- 6EM3 futures = 1.0620
- Contract size: €125,000
Next, the asset manager determines how many futures contracts they need to create the FX overlay by taking the risk position and dividing it by the contract size.
€472.77M / €125,000 (6E unit size) = 3782 6EM3
The asset manager decides to buy 3782 June EUR/USD futures contracts at 1.0620 to put on a currency overlay. This would require an initial margin of around $10.2M (3782 x $2,700 per contract). The asset manager’s position will benefit if the U.S. dollar goes down in value or if the euro goes up in value.
Results
By June 15, SPX is higher and EUR/USD is stronger:
| February 28 | June 15 | |
|---|---|---|
| SPX | 3970.15 | 4425.84, up 455.69 points or +11.5% |
| EUR/USD spot | 1.0576 | 1.0937 |
| 6EM3 | 1.0620 | 1.0951, up 331.0 points |
The basis differential, or the price between spot and futures, is now 14.0 points (1.0951 - 1.0937) when it was 44.0 points at entry. This indicates that the currency futures have converged down in price (since it is trading at a premium) relative to spot by 30 index points.
Equity position vs. FX overlay
The 11.5% gain on the $500M equity position would result in a $57.5M gain. However, this still needs to be converted back into euro. Since there was an increase in value of the euro relative to the U.S. dollar, when it converted back at 1.0937, the position only produced €509.74M or a 7.8% return on capital.
The asset manager implemented the currency overlay to offset this type of move. Being long the FX futures resulted in a 331.0 point increase on the 3782 EUR/USD futures contracts, resulting in a gain of $15,648,025 (331.0 points x 3782 contracts x $12.50). Once converted back into euro at 1.0937, the position produced €14,307,420 gain.
The equity position with the FX overlay results in a net return of €71.8M.
Net = €509.74M + €14.3 = €524.04M, or 10.8% gain
The 10.8% ROC is closer to the 11.5% increase in SPX, considering the ROC would have been 7.8% had the asset manager not implemented the currency overlay. The overlay reduced the loss due to currency fluctuation.
Conclusion
Currency overlays can be used to address currency risk in many different scenarios, as FX rates can change for a variety of reasons from central bank policy meetings to shifts in the supply chain. The purpose of a currency overlay program is to limit losses and maximize gains that arise from currency risk.
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