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Hedging: Making the uncertain certain

Thiveyen Kathirrasan & Felicia Tan
Thiveyen Kathirrasan & Felicia Tan9/18/2022 12:09 AM GMT+08  • 6 min read
Hedging: Making the uncertain certain
What hedging is all about and the different ways of hedging. Photo: Shutterstock
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“As value investors, our business is to buy bargains that financial market theory says do not exist. We’ve delivered great returns to our clients for a quarter century — a dollar invested at inception in our largest fund is now worth over US$94 ($132), a 20% net compound return. We have achieved this not by incurring high risk as financial theory would suggest, but by deliberately avoiding or hedging the risks that we identified” — Seth Klarman, American billionaire investor, hedge fund manager and author

Throughout this column, we have shown that diving into investing is not as complicated as it seems. Even so, financing involves risks — as in everything else.

Hedging is one way to reduce investment risks and losses. It is a method for investors to ensure that there is insurance to protect themselves against a specific threat, such as currency fluctuations or differences in trading costs.

It also means investors limit their variables, profits, and losses to the specific stock, asset class, or instrument. Hedging ensures that their money will come from the actual progress of the business. What matters here is that hedging allows investors to optimise the costs of transacting the stock.

When the investor chooses to buy a specific stock, the transaction costs and currency fluctuations of the position should not be a significant or material factor affecting the investor’s return objectives, which helps with hedging.

When buying a stock, the entry point for the day may not be the highest or lowest price ever. The investor may not even know how much they will spend. They might want to fix other costs and leave only the stock price as the variable item. If investors are looking at purchasing global stocks or stocks listed in countries other than their own, then the currency is usually set at the highest cost.

See also: Why inflation heats up and is so hard to cool down

Suppose an investor here is looking to buy a Japanese-listed stock. In that case, they will have to convert Singapore dollars (SGD) into Japanese yen (JPY), usually done by the investor’s broker, before purchase. The conversion will be made the moment they are looking to buy the stock.

Should they decide to sell the same stock later, the exchange rate between the SGD and JPY would have changed, which would be a cost if the JPY weakens against the SGD. What hedging does — in this case — is to fix the exchange rates at the point of purchase. The investor would set the JPY to SGD as a typical retail investor to hedge the acquisition.

Hedging through contracts for differences

See also: Top 5 mistakes that investors and traders make

There are different ways to hedge. One way is through a so-called contract for difference (CFD), a contract between an investor and a CFD provider that trades the difference in the value of a security over a fixed time. The difference between trading a CFD and a stock is that the former does not require ownership of the underlying asset, while the latter does.

In this case, if an investor is looking to spend $1,000 to buy the Japanese-listed stock, they would purchase several CFDs and pay the difference between the starting and closing price, with the JPY against the SGD. By trading a CFD, an investor will not be caught off guard due to any difference in exchange rates from when SGD is converted into JPY.

To hedge against an investor’s bet on the Japanese stock market, they would want to buy a CFD of the inverse, which means purchasing the SGD against the JPY in case anything happens to the JPY. If, during this period, the JPY depreciates by 10% against the SGD, the investments would reduce by 10%. However, as the CFD is betting on the SGD appreciating against the JPY, that gain would offset the investor’s trading account loss. Remember that the reverse will also happen if the JPY appreciates the SGD.

The investor can buy the CFD at a one-to-one ratio to fully hedge the trade. One advantage of CFDs is that investors do not need to put money upfront since they are not required to own the underlying asset. Instead, they will only need to pay the difference on the settlement date, which can be fixed. The distinction refers to any change in an amount from their opening and closing prices.

One point to note is that when an investor exits the counter, they should also liquidate the CFD. If they are not expecting the currency they are trading in to fluctuate; then a CFD may not be necessary.

When should you buy a CFD when buying a listed stock in another country?

In a nutshell, an investor might want to do so when their investment amount is a significant one, and currency fluctuations may cost several hundred dollars.

For more stories about where money flows, click here for Capital Section

Buying a CFD or other similar financial instruments will involve a small transaction fee. This is a small cost compared to the amount they would usually be investing if they are hedging one-to-one unless the investment amount is minimal and would not make much difference.

Things to consider

Before hedging investments, consider other costs that — even if they do not seem significant at that point — will still add up after several trades. These include brokerage fees, with differences seen for direct accounts versus nominal or custodian charges.

An investor’s stocks — and the subsequent dividends — are deposited in their personal account. These brokerages, usually banks, cannot use these investments for their purposes unless otherwise authorised.

But with nominal accounts, an investor is essentially nominating the third party — in this case, the broker — to take custody of their stocks. Active traders may also want to consider hedging their transaction costs, such as brokerage commissions, as they can add up.

Other forms of hedging

Hedging is not just applicable to investing in individual stocks. They can be used to identify companies that are worth buying.

For instance, some S-REITs have been caught flat-footed due to rising interest rates. S-REITs, which have assets in other countries, have also been affected by currency fluctuations.

To minimise these risks, investors should look at S-REITs that have hedged against the rising interest rate environment. These S-REITs have entered into fixed-rate debts or hedged through floating-to-fixed interest rate swaps.

Look out for S-REITs’ revenue, especially calculated in foreign currencies. Another factor to watch out for is companies with higher gearing ratios, meaning they have a higher proportion of borrowed funds to their equity. A higher gearing ratio indicates a company will be more affected by rising interest rates.

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