Exchange rate fluctuations can wipe out or augment your return from a foreign stock investment. Is there any way to protect yourself from such risk?
Let's make a few assumptions:
- you are a US$ investor
- you want to invest in a € denominated stock
- you want a perfect hedge: if you buy the equivalent of $1,000 of the stock at €100 and sell it at €120, you want to receive a profit of $200 regardless of the fluctuations of the €/$
You have several ways of achieving (almost) that, in ascending complexity:
- your broker may allow you to buy the € stock in €, which will create a debit € balance on your account. In that case, leaving the debit balance as is works effectively as a hedge. Note however that you will be charged a fee on the debit which may be significant depending on your account terms (unlikely to be less than 0.4% per annum for an individual). Alternatively you could use an FX broker to do the same and the cost will be similar.
- you can sell a €/$ future contract. But the notional (~$150k) may be too high vs. the size of your investment (there is a mini version which is half the size). Also note that you may receive margin calls along the way so you need to be adequately funded.
- you can buy the investment through a CFD or equity swap denominated in €: your €/$ exposure will be on the P&L only
- you can sell a €/$ forward but that is generally not available to individual investors - it works like a future.
- you can use options but the frictions are higher and you may not achieve what you expected depending on the options characteristics (time value, convexity etc.)
Note that each alternative will have a cost which can be small (forwards, futures) or large (CFDs, debit) and the hedge will never be perfect, but you can get close. You will also need to decide whether you hedge the unrealised P&L on the position and at what frequency.