Developing hedging strategies when investing is a core aspect of financial planning. In a world full of uncertainty and price volatility on the foreign exchange markets, we need to protect our investments. We are often faced with foreign exchange risks that can have a significant influence on our portfolio.
In this article, we look at how to determine hedging requirements and find appropriate hedging solutions. We will look at how to identify risks, select suitable instruments, and develop a comprehensive plan. Moreover, we will discuss how to implement these strategies and align them with our risk tolerance and risk appetite.
Identifying investment risks
When developing hedging strategies for investments, it is important to first identify the kinds of risks we are dealing with. While investments always entail risks, a thorough analysis helps us recognize potential dangers early and take appropriate measures.
Understanding market risks
Market risks, also referred to as systemic risks, refer to uncertainties caused by macroeconomic factors. These risks affect the entire financial market and cannot be mitigated through diversification. Among the most important market risks are interest rates, inflation, political developments, and economic recessions. A political crisis, for instance, can result in falling equity prices.
To successfully deal with market risks, it is important to monitor the overall economic and financial situation. Economic recessions, financial crises, changes in interest rates, and political uncertainties can impair market stability and increase our investment risk. A stable macroeconomic environment characterized by healthy growth and declining inflation, however, reduces investment risk.
Identifying currency risks
Currency risks arise when we trade or invest in different currencies. They refer to the uncertainty about the exchange rate between the foreign currency and our reference currency at a defined moment in the future. Currency risk is particularly relevant for export-oriented companies that sell their products abroad.
For example, if we as a Swiss exporter agree with a customer in the eurozone that the invoice should be paid in euros, our currency risk is that, at the time of settlement, we may receive less in euros than we initially calculated. This can significantly impact our revenue and liquidity.
Assessing political and economic risks
Political and economic risks can significantly affect our investments. These risks include changes in government policies, geopolitical tensions, trade embargoes, or sanctions. Developments in this regard can happen very quickly and restrict our imports or exports.
Unexpected events such as the COVID-19 pandemic or the Ukraine war can disrupt supply chains and increase currency volatility and inflation. As a result, they can negatively influence our company revenue.
To deal with these risks, it is important to have a detailed understanding of our company's cash flow and liquidity. An overview of these factors forms the basis of effective hedging and helps us identify currency risks early and take appropriate measures.
Selecting appropriate hedging instruments
When developing hedging strategies for investments, selecting appropriate hedging instruments is decisive. We need to carefully weigh which hedging solutions are most suitable given our risk profile and investment objectives.
Options and futures
Options and futures are important tools in our hedging toolbox. Options allow us to hedge against unfavorable price movements while benefiting from positive price movements. When buying a put option, we hedge a long equity position, for example. In doing so, it's worth noting that the underlying and the options price do not always move proportionally. The so-called delta of an option provides information about this ratio.
Futures are also a way to hedge securities positions. They are particularly suitable for companies that need to cover long-term commodity requirements or hedge foreign currency risks. For example, wheat futures contracts enable a bread producer to secure a fixed wheat price for the entire term of the contract, reducing a risk to this particular business.
Currency hedging via forwards
Forwards are a widely used tool to hedge against foreign exchange risks. A forward allows us to fix the exchange rate for future payments today, creating security in planning and protecting us against unexpected currency devaluation. One particularly flexible instrument in this regard is the UBS Flexible FX Forward, which allows us to set an exchange rate in advance and withdraw the necessary partial amounts whenever we need them.
Currency hedging costs are usually taken into account in the exchange rate that is used, meaning that many hedging methods do not result in any additional fees. Proactive hedging is recommended for a foreign exchange volume of around CHF 100,000 a year.
Use of ETFs to diversify risks
Exchange Traded Funds (ETFs) are a valuable instrument to diversify risks in our portfolio. They enable us to invest in various asset classes, countries, and sectors at low fees. To achieve sufficient diversification, we should invest in at least two ETFs whose investment focus differs.
One popular approach is a 70:30 portfolio, with 70% is invested in developed economies (e.g., MSCI World) and 30% in emerging markets (e.g., MSCI Emerging Markets). This helps us avoid concentration risks and achieve broad, global diversification.
In selecting hedging instruments, we must always keep in mind our individual risk tolerance, investment horizon, and investment strategy. It is advisable to combine various instruments to create a balanced, well-diversified portfolio. In the end, it's about striking a balance between security and return opportunities that are aligned with our requirements and objectives.
Developing a hedging plan
When developing a hedging strategy for our investments, it is essential to first establish a detailed hedging plan. This plan is the foundation for a solid financial situation and helps ensure the stability and growth of our investments.
Defining hedging objectives
When making a hedging plan, the first step is to define clear objectives. We need to ask ourselves what we wish to achieve with our hedging strategy. Is it to minimize currency risks, balancing price fluctuations on the currency markets, or protecting our portfolio against unexpected market developments? The more specific our objectives are, the better we can align the characteristics, opportunities, and risks of our hedging instruments with our stated goals.
Determining the ideal degree of hedging
Determining the ideal degree of hedging is an important aspect of our strategy, which requires us to take into account our individual risk appetite and risk tolerance. Too high a hedging degree may minimize risks but also limit potential returns. Yet too low a degree can expose us to unnecessary risks.
For example, in currency hedging, a hedging degree or 65% might be appropriate for a moderately risk-conscious investor. In other words, 65% of our foreign exchange positions should be hedged, while 35% remain unhedged to benefit from potentially favorable currency movements.
Cost-benefit analysis of various strategies
An in-depth cost-benefit analysis helps us identify the best hedging options for our portfolio. This analysis must compare the costs of various hedging instruments with the potential benefits and hedges, including a detailed assessment of premiums, covered sums, and conditions of the various hedging solutions.
For instance, in currency hedging, we should compare the costs of various instruments such as forwards or options. In doing so, we should keep in mind that the costs of currency hedging are usually included in the applied exchange rate. Proactive hedging is recommended starting at a foreign exchange volume of around CHF 100,000 a year.
When drawing up our hedging plan, it's important to remain flexible and regularly review our strategy. Planning and developing hedging strategies for investments is not a one-time event, but an ongoing process. We need to be willing to adjust our plan should market conditions or our own circumstances change.
By developing a carefully considered hedging plan that takes into account our objectives, our ideal hedging degree, and an in-depth cost-benefit analysis, we can effectively protect our investments while leaving room for growth and returns. This enables us to look ahead with confidence and position our portfolio in the best way possible.
Strategy implementation and adjustment
Implementation and continuous adjustments are also essential when developing a hedging strategy. Being flexible in responding to changes in market conditions can allow us to be successful in the long term.
Step-by-step implementation
The gradual implementation of our hedging plan is key to success. We start by defining clear objectives for our strategy and determining which risks we wish to minimize and which results we would like to achieve. Based on that, we then identify the appropriate hedging instruments and gradually implement them in our portfolio.
In this context, rolling hedging is a tried-and-tested strategy that allows us to adjust our hedges to market conditions over time. The time horizon of such a strategy tends to be long term, as we need to adjust the hedges continuously.
Continuous market monitoring
As part of our strategy, we need to continously monitor, analyze and gather relevant information about the market in which we are active. This enables us to gain a deep understanding of current market trends, client requirements, and the competitive landscape.
By continously monitoring the market, we can recognize trends and new opportunities early. At the same time, doing so enables us to identify risks such as changes in demand or in the legal conditions early on and react accordingly. To benefit from the results of our monitoring, we should carefully document our findings and draw specific conclusions from them.
Flexibility in the face of changing market conditions
In the constantly changing world of finance, it's crucial to remain flexible in adjusting hedging strategies. We must be prepared to reassess our strategy and adjust it in line with market developments. This requires us to regularly re-examine and re-evaluate our hedging positions.
A dynamic approach to currency hedging can be particularly valuable in this regard. For instance, based on the current spot rate, we can define certain levels for a standard forward, risk reversal, or participating forward, making it possible to profit from favorable market movements while ensuring protection in the event of unfavorable events.
When making adjustments to our strategy, it's also important to consider various forward-looking scenarios and their potential impact. Together with our foreign exchange advisors, we should always analyze the current situation and determine a specific target for the level of hedging.
Implementing and adjusting our hedging strategy is an ongoing process. We need to remain vigilant, carefully monitor market developments, and be prepared to adjust our strategy if needed. This is essential to ensure that our investments are best protected while we can benefit from positive market developments.
Adhering to these principles, we can establish a robust and flexible kind of risk management, making it possible to achieve our financial goals while effectively steering any investment-related risks.