How to Hedge Currency Risk? [for US ex-pats and non-US investors]

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dphilipps
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How to Hedge Currency Risk? [for US ex-pats and non-US investors]

Post by dphilipps » Sun Apr 22, 2018 10:00 am

As a FIRE'd US citizen who spends most of the year outside of the US, I've never really paid much attention to currency hedging -- I figured in some years my foreign travel would be cheaper, in others, it would be more expensive, and it would all balance out in the long run. I'm reconsidering my stance, having come to the conclusion that less volatility in my annual withdrawals would lower the probability of prematurely spending down my portfolio.

My 60/40 portfolio allocates equities 45/55 between US and international. I have 10% of my fixed income in local-currency emerging market bonds, the rest in CDs, treasuries and muni bonds. Hence, my portfolio already holds nearly 40% in non-USD-denominated assets, but I'd like to increase this ratio even further.

My options as I see them:

A. Move some of my fixed income into unhedged foreign bonds: I've looked in vain for a reasonably-priced fund. I'm ok with paying nearly 50bp for local-currency EM, but paying a highish expense ratio for widely-traded developed-country issues like bunds and gilts feels like a rip-off.

B. Open accounts at European banks and buy CDs directly in EUR or GBP: This appears to be a major hassle (and may not even be possible for a non-resident).

C. Use FX futures or forward contracts to hedge my USD exposure: I'm gravitating towards this option, as it appears to be the most flexible approach, and I'd like to continue holding my underlying FI assets in CDs and munis (I'm picking up a decent yield premium through various CD specials, and holding illiquid issues to maturity).

I have a rough understanding of FX hedging, but I'm unsure how to implement it in practice. Would someone be able to walk me though the steps of implementing an FX strategy? For example, assume I'm looking to spend 50,000 euros a year for the next 5 years, and I'd like to either lock in the current exchange rate, or at least cap my exposure to $1.30 USD/EUR. In terms of cost, am I correct to expect to pay the interest rate differential (currently about 2% per annum) of the amount hedged? How would my gain/loss be taxed, and is it possible (and advisable) to hold the contracts within a tax-advantaged account?

I haven't found anything on this topic on the wiki. I'd be happy to summarize answers to this post for a new wiki page -- it appears there are loads of expats/non-US investors on this board who might benefit from this information.

Thanks in advance!

mc7
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Re: How to Hedge Currency Risk?

Post by mc7 » Sun Apr 22, 2018 2:19 pm

Thanks for starting this thread. I think the US dollar carries risk, not only relative to foreign travel, but also in case of a dramatic move relative to other currencies. I am certainly no currency expert, but my impression is that the past forty years have been unusually stable for the dollar. I don't assume the dollar will remain the world's reserve currency; even if that's the most likely outcome, there is no guarantee. Nor do I think this means armageddon, stockpiling guns and ammo, and giving up. We could find ourselves getting by in a world where the dollar is simply not worth what it once was.

People talk about "expenses denominated in dollars," as a reason for steady future income in dollars, but unless the dollar amounts are contractually or legally guaranteed, I'm not really sure what that means. Just because I pay for avocados in dollars doesn't mean I can predict their price. This seems like money illusion and/or home country bias.

In addition to foreign stocks, I have unhedged foreign bonds. That goes against both the majority Boglehead opinion and Vanguard's policy, but on the flip side, I can't talk myself into US government bonds being better under all (bond-favorable) scenarios than other developed market government bonds.

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Re: How to Hedge Currency Risk? [for US ex-pats and non-US investors]

Post by LadyGeek » Sun Apr 22, 2018 2:34 pm

This thread is now in the Investing - Theory, News & General forum (general discussion). I also retitled the thread for clarity.

If someone can suggest content for the wiki, post here.

dphilipps - If you want to become a wiki editor and write the article yourself, please PM me.
Wiki To some, the glass is half full. To others, the glass is half empty. To an engineer, it's twice the size it needs to be.

Valuethinker
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Re: How to Hedge Currency Risk?

Post by Valuethinker » Sun Apr 22, 2018 3:46 pm

mc7 wrote:
Sun Apr 22, 2018 2:19 pm
Thanks for starting this thread. I think the US dollar carries risk, not only relative to foreign travel, but also in case of a dramatic move relative to other currencies. I am certainly no currency expert, but my impression is that the past forty years have been unusually stable for the dollar. I don't assume the dollar will remain the world's reserve currency; even if that's the most likely outcome, there is no guarantee. Nor do I think this means armageddon, stockpiling guns and ammo, and giving up. We could find ourselves getting by in a world where the dollar is simply not worth what it once was.

People talk about "expenses denominated in dollars," as a reason for steady future income in dollars, but unless the dollar amounts are contractually or legally guaranteed, I'm not really sure what that means. Just because I pay for avocados in dollars doesn't mean I can predict their price. This seems like money illusion and/or home country bias.
That's what ibonds and TIPS were invented for, though? To hedge against domestic inflation. The point is that future healthcare bills will be settled in dollars. Future property tax bills. Future utility bills. Future homecare bills.

The US has a surprisingly low foreign trade sector, compared to say Japan, Germany or UK (not sure against Eurozone as a whole). And it's unique among developed nations for moving rapidly towards self sufficiency in hydro carbon fuels. Within even 5 years, the US might be self sufficient (it will always export, and it will always import, from Canada and probably Mexico, because that's where the pipelines run and, under NAFTA, these are de facto American oil and gas reserves. It may still import some oil (ex Canada and Mexico) but it's likely to be a significant LNG exporter).
In addition to foreign stocks, I have unhedged foreign bonds. That goes against both the majority Boglehead opinion and Vanguard's policy, but on the flip side, I can't talk myself into US government bonds being better under all (bond-favorable) scenarios than other developed market government bonds.
Except US Treasuries pay a lot higher yields?

Risk free Eurozone bonds (German bunds) pay nearly 0 per cent nominal. You go to Italy, say, you get over 1.0%- the market clearly does not believe Italy is at zero risk of default/ restructure/ exit of Euro.

Japan? You get 0.5%. A Bank of Japan commitment to get inflation to 2.0% by devaluing the currency.

British? Gilts pay 1.5% yield (ish), inflation is 2.7%. Indexed Linked Gilts have real yields of -1.5% (on 3.0% inflation expectation).

Running out of places -- Australian, Canada, Sweden. All 3 have unsustainable housing bubbles. I don't really expect a default, but the currencies won't look pretty when the bubble bursts. My own thought is the CAD could go to 50 cents (previous low in the early 2000s was 61.79 cents US). On most measures of expensiveness, household mortgage debt and proportion of GDP devoted to real estate related activities, Australia & Canada are more exposed to their housing markets than the US was... in 2006.

You pays your money and you takes your choice. The higher US yield reflects the stronger economy and the presumption that, at some point, the Fed will tighten. However if the USD devalues then that is going to make that moot.

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Re: How to Hedge Currency Risk? [for US ex-pats and non-US investors]

Post by whodidntante » Sun Apr 22, 2018 4:45 pm

I'm not an expert in futures but I can tell you a few things. Some of it might even be correct.

First, understand the contract you are buying. Here are some commonly traded forex contracts.
http://www.cmegroup.com/trading/fx/

Click "contract specifications" on the one of interest. There are contracts for Euro and GBP. Also look at the "maintenance margin" tab. You'll find you can get a lot of exposure for a little capital. If you drop below maintenance margin, your broker might forcibly close your positions. Your broker might impose a more stringent maintenance margin than is required for the contract.
http://www.cmegroup.com/trading/fx/g10/ ... tions.html
http://www.cmegroup.com/trading/fx/g10/ ... tions.html

The contract unit is very important. This tells you how much exposure you buy with one contract. Unfortunately the euro contract provides more exposure than you asked for in your example. So you can't use futures if that was your actual use case. The product code tells you the ticker, but you will easily be able to find that at your broker. The currencies you asked about are commonly traded.

Since these are physical delivery contracts, you will want to roll the contracts, since you don't actually want to take delivery. You can put in an order to do this as one transaction, if you like. I believe that is called a calendar spread. But at any rate, "rolling" means you close the position you opened, and open a new position further out.

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Re: How to Hedge Currency Risk? [for US ex-pats and non-US investors]

Post by CascadiaSoonish » Sun Apr 22, 2018 5:44 pm

dphilipps wrote:
Sun Apr 22, 2018 10:00 am
I'd be happy to summarize answers to this post for a new wiki page -- it appears there are loads of expats/non-US investors on this board who might benefit from this information.
Please do. Speaking from experience, this would be useful information. In 2002 my partner and I carefully budgeted for a year in the EU when $1 bought €1.15 or so. One year later we were needing to draw down our US accounts a lot faster than planned as $1 was only worth €.90 at that point. Painful.

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whodidntante
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Re: How to Hedge Currency Risk? [for US ex-pats and non-US investors]

Post by whodidntante » Sun Apr 22, 2018 7:03 pm

I found this e-micro contract that is more granular. It would work fine for your example. You would buy four contracts.

http://www.cmegroup.com/trading/fx/e-mi ... -euro.html

AlohaJoe
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Re: How to Hedge Currency Risk?

Post by AlohaJoe » Mon Apr 23, 2018 11:13 am

mc7 wrote:
Sun Apr 22, 2018 2:19 pm
I am certainly no currency expert, but my impression is that the past forty years have been unusually stable for the dollar.
I don't see any evidence of that in the Federal Reserve's trade weighted U.S. dollar index, even when compared against the Bank of England's sterling index or the Bank of Japan's yen index.

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Re: How to Hedge Currency Risk? [for US ex-pats and non-US investors]

Post by AlohaJoe » Mon Apr 23, 2018 11:18 am

dphilipps wrote:
Sun Apr 22, 2018 10:00 am
For example, assume I'm looking to spend 50,000 euros a year for the next 5 years, and I'd like to either lock in the current exchange rate, or at least cap my exposure to $1.30 USD/EUR.
I don't quite follow how this would work. Why five years? At the end of five years you'd then get all at once by the full brunt of the swing against you, right? Or is the idea to roll them over every year so you've always got five years worth of hedging? If so, why not just go with a single six month contract? Or is the idea that five years gives you enough time to adapt your standard of living? Or is five years enough that maybe things swing back? What if they don't?

As an early retiree, aren't you actually looking to spend €50,000 a year for the next 50 years? So don't you need to lock in the current exchange rate for 50 years?

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Re: How to Hedge Currency Risk? [for US ex-pats and non-US investors]

Post by galeno » Thu May 17, 2018 7:32 pm

I'm a USA-NRA w/o USA tax treaty. I live near the USA. My local currency is the USD.

SUAG:LSE (USA Bond Market ETF) has an ER = 0.25% and a YTM = 3.51%. Subtract the ER from the YTM and we get a NET YTM = 3.26%.

AGGG:LSE (Global Bond Market ETF) has an ER = 0.10% and a YTM = 2.00%. Subtract the ER from the YTM and get a NET YTM = 1.90%.

Is the diversification away from some USD bonds worth a loss of 1.36% (42%) yield of the 100% US bond index?

I would have to say NO.
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 3.0%. TER = 0.4%. Port Yield = 2.0%. Term = 35 yr. FI Duration = 6.2 yr. Portfolio survival probability = 100%.

ge1
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Re: How to Hedge Currency Risk? [for US ex-pats and non-US investors]

Post by ge1 » Thu May 17, 2018 9:23 pm

I would simply open a FX brokerage account and buy EUR or whatever currency you want to have exposure to. A lot of people have a negative view of FX trading, but it’s actually very simple. I had an account for a few years, I think it was with Forex.com, and it worked well.

A few things to look out for:
- Leverage is a powerful thing, you can buy large amounts of foreign currencies with little money down, so be careful only to buy as much Euros as you need. It’s tempting to try and make a few extra $ with speculating in currencies, but that’s a dangerous game.
- Make sure you understand how the interest works. If you are long EUR / short USD, that FX pair would likely have a negative interest, as the interest rates in the US are higher. This can become costly over time. The brokers have good examples on their website, make sure you understand them.

Good luck

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