Forex Queries

It is becoming increasingly evident that the corporate currency manager and the currency speculator have much more in common than either are willing to own up to (the speculator considering himself a breed apart, and all). Both are at risk of financial loss in unpredictable markets. The cash exposure carried by the corporation is no different from the market exposure of the speculator. They are managed in a similar fashion.

Paradoxically, the risk disappears for both when the currency manager gets into the market and the speculator gets out; both assume exposure risk when the hedger steps out of the market and the speculator steps in.

This being the case, imagine a scenario in which one currency manager and one currency speculator transact with each other, each hoping to profit from a trade in which only one will. If the speculator is seasoned, he is probably trading as mechanically and impassively as he knows how, aided by a system that’s calling the shots. If he is doing it right, he planned the trade in advance, and now he’s trading the plan. The currency manager should do the same.

It is to the currency manager’s advantage, therefore, to know the rules of the game. They are listed below in no particular order. Most, but not all, were developed by speculators who validated them by painful experience. Others pertain specifically to hedging. They will all serve the currency manager equally well.

1.Do not “Texas hedge.” A “Texas hedge” is not a hedge at all-it is speculation. Unless the market exposure is in the opposite direction from the cash exposure, the company is not hedging. Also, to the extent that the exposure is over-hedged or under hedged, the company is speculating, either in cash or derivatives.  

2.Be sure of your position. Simple transactions are obviously long or short, but the more complex a hedge becomes, the less obvious the positions may be. Convoluted option strategies and option embedded counterparty agreements may be difficult to unravel into component longs and shorts. Thoroughly pick apart all derivative strategies and identify each component by amount, duration, and position.

3.Calculate your equity balance daily. Foreign exchange and futures accounts should be marked to the market daily. It is all too common for huge losses to accrue undetected until it is too late to salvage the program.

4.Do not over-leverage. Figure out the worst case scenario and make sure funds are available to back up the market position if it occurs. In regard to futures positions, delays in meeting margin calls can result in unrealized losses suddenly becoming realized without the currency manager’s knowledge. Recognizing this, most brokers and dealers have standing instructions to liquidate an overdue margin position immediately, at the market, with or without the client’s approval.

5.Do not lift hedges prematurely simply to stem a loss. If the hedge is sound, liquidating it to cut a loss will leave the exposure vulnerable to a price reversal. There is nothing worse than getting out of the market with a realized loss only to see additional losses accumulate in the exposed position as prices suddenly go the other way.

6.Do not lift hedges prematurely simply to take a profit. It’s tempting to take profits, especially after agonizing through a string of trading losses. It is tempting to want hedging positions to produce profits, even more than cash positions. It is easy to rationalize profit-taking believing that the market has gone too far, too fast. It seems so certain that there will be an opportunity to re-establish the hedge at a better price. Too often, there is no better price. A characteristic of market trends is that they keep going much farther than anyone expects. Hedge profits can quickly dissipate as the now unheeded exposure generates losses.