Derivatives In Your Currency-Hedged ETF Are Safe

July 28, 2015

Currency-hedged ETFs remain extremely popular in the face of a strong dollar. For U.S. investors, currency-hedged ETFs provide access to the returns of stocks in overseas markets without any losses or gains from movements in the foreign currency.

While these ETFs inoculate investors from currency risk, they do so using tools sometimes considered synonymous with wild-eyed financial risk: derivatives.

Are investors jumping out of the frying pan and into the fire? How can they assess the risk of tools so complicated that even the smartest guys at the biggest banks sometimes mess up?

My view: Derivatives in hedged ETFs do their job without taking on much additional risk from the instruments themselves. More bluntly, hedging the currency risk out of Europe or Japan equities may or may not prove to be a good call, but the impact from any derivative blowup or malfunction is likely to be small. Let’s break it down to see why.

Collateral Damage

While derivatives can be complex, it helps to consider exactly what’s at risk. Derivatives like currency forwards don’t necessarily require any money to change hands at the outset. So where does my cash actually go?

For currency-hedged funds, all my cash goes to buy the underlying stocks. If I’m investing $100 in the stocks in the Nikkei average and hedging the yen/dollar cross, my $100, translated to yen, buys the stocks, and $0 goes to the derivatives at the outset. (I have $100 worth of short yen exposure with no capital expended.)

In this respect, my “collateral” is the basket of stocks. But wait, shouldn’t collateral be in safe T-bills and not risky foreign equities? Not in this case. First, there’s no “extra” cash to park in T-bills; it all goes to buy the stocks. Second, the risk in Japanese stocks is the risk I want in the first place—that’s what I’m buying when I buy the ETF.

Counter(party) Culture

Now, let’s think about the two parties in the currency hedge. Before the hedge, my ETF sold dollars, bought yen and then bought the stocks, so I’m long yen and long the Japanese stocks.

The derivative hedge then is short yen to offset my original long yen position to leave me with just the local performance of the Japanese stocks.

Since I’m short, if the yen rises, I owe the counterparty money. If it drops, the counterparty owes me money. The second scenario is the one I’ll worry about more—will I get paid? The key point here: It’s my currency gain that’s at risk if the yen drops and the counterparty walks away, not all my original capital.

Still, it’s not pure gravy that’s at risk. The gain from derivatives in the falling yen scenario offsets my embedded, unrealized loss in my position in Japanese stocks as a U.S. investor, even if there are no changes in share prices counted in yen. So there’s downside risk here.

Monthly Resets
Still, currency forwards in most FX-hedged ETFs are reset monthly, so that puts a time-based cap on my exposure. (Some issuers may net positions with counterparties more frequently, but I’ll assume “worse case.”)

In short, if the derivative blows up, I’m unhedged on the downside for currency moves only, just as if I held a plain-vanilla Japanese ETF.

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