Reduce Investment Risks with Hedging Strategies

To navigate the rapidly evolving foreign exchange market, the economist Andy Cheuk-Chiu Kwan has always adhered to his investing principle - implementing adequate risk-mitigating measures.

Andy Cheuk-Chiu Kwan holds a number of government positions as well as conducting academic research. He is a member of the Public Affairs Forum of the HKSAR and a member of the Long Term Housing Strategy Steering Committee. Although Kwan has a heavy workload and is physically fit, he believes that taking preventive steps - such as doing more exercise and avoiding unhealthy and junk food - is better than cure when it comes to staying healthy, as these precautionary measures can help to avoid health issues.

Hedge Against Risks with Safe-Haven Currencies

Foreign exchange investing is comparable to maintaining one's health, as both require us to plan ahead for "rainy days", Kwan believes. "Although the foreign exchange market seems calm at the moment, we still need to prepare for rough times by having risk control measures in place. When major market events are looming on the horizon, such as the FOMC meeting and referendums in European countries, even though we cannot foresee the outcomes, we can still contain the impact of such events on our investment portfolios by taking appropriate action to reduce risks."

Risk management tools abound in the investment market. Kwan believes that in the foreign exchange arena, one could first learn to utilise safe-haven currencies, such as the Japanese Yen, Swiss Franc and so on to try to mitigate risks. Whenever the investment landscape turns choppy, these kinds of currencies tend to appreciate, which makes them one of the tools for hedging against risks.

"A case in point is on the eve of the result announcement of the Greek referendum in July in 2015. We were all well aware that the Euro was bound for significant fluctuations. If you were holding Euros and did not want to bear undue risks, you might have considered converting part of your Euro holdings into Japanese Yen. By doing so, you may have been able to offset some of the losses in Euro with gains in Yen, the appreciating safe-haven currency, even if the market situation worsened; on the contrary, if the market remained uneventful and the Euro appreciated, the Yen could still serve as a protection." Hedging is like exercising: while a lack of physical activity does not necessarily make you sick, doing exercise may help you reduce the risks of developing health problems, Kwan says.

Lock In Costs by Making Flexible Use of Margin

Preparing for the overseas education of children is a common purpose for people in need of foreign currencies. Kwan suggests that people could consider using margin to lock in the cost of buying foreign currencies. "Most people think that margin involves a high level of risk, but this may not entirely true. In fact, using margin on foreign exchange investment only requires a low minimum amount of initial capital. You can make use of this tool to suit your own needs, financial situation and level of risk tolerance, and hedge against foreign exchange risks."

Kwan often visits his parents in Canada, and he usually brings some Canadian Dollars (CAD) along with him for daily expenses. The rally in the commodities market a few years ago has propelled a surge in the exchange rate of CAD. Kwan uses this as an example of how we can manage risks with margin: "At that time, CAD1 was equivalent to about HKD6.5. If I considered this exchange rate reasonable for buying in CAD, I could lock in the exchange rate by using margin. Suppose I am using a leverage of 10 times, I will only need to deposit 10% of the contract value to obtain a long exposure in CAD10,000 (that is, to enter a contract of CAD10,000 by depositing CAD1,000 or HKD6,500 equivalent. This represents a bullish view on the exchange rate of CAD against HKD)."

"Assume that, after one year, the exchange rate of CAD rose and CAD1 can buy HKD8, so the gain of the future contract will be able to offset part of the cost of purchasing CAD in the future. If the CAD depreciated, rather than appreciated, to CAD1 to HKD5, the long position of the future contract will incur a loss, but the cost of buying the CAD in the future will be reduced, which can offset the loss. In other words, I can lock in the future price of CAD by entering a margin contract, which costs only one-tenth of the notional amount of the contract." Kwan also advises that investors must consider their own level of risk tolerance when they use margin, and be aware that if the foreign exchange margin contract incurs excessive losses, it may be liquidated prematurely.

Lastly, Kwan reminds us that some major events may also bring large swings to the foreign exchange market. For instance, the US presidential election, the FOMC meeting in the US and etc. The need for sufficient hedging is warranted for consideration, he cautions.

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