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:
