Foreign currency actions and currency risk (4/4)

In our last article, we have seen what possibilities Forex offers to hedge against exchange rate risk. It is an effective method but also involves risks for those who are not comfortable with this type of instrument. Let us also remember that a complementary approach is to diversify your portfolio with securities in local currency, but that this method is limited and not very effective if used in isolation. There remains one possibility that we have not addressed, one that we had immediately left aside because we wanted to limit the share of assets in foreign currency.

What if the best way to hedge against exchange rate risk was to cure evil with evil, namely investing in dollar-denominated securities (for example), which can benefit from a fall in the greenback? This is typically the case for large American multinationals that generate a majority of their turnover outside the United States, such as McDonald's Or Coca-Cola. There is also the raw materials sector, particularly the oil industry (Chevron), who reacts in this way.

We consider volatility to be an inherent risk for the investor. A security that fluctuates sharply up or down is not necessarily riskier in itself, but it can be riskier depending on the investor's feelings of fear and greed, leading them to make bad decisions. For this reason, we have always taken into account thestandard deviation actions in our strategy. Where it gets interesting is calculating this volatility not in the original currency of the title, as is customary, but in our reference currency, as we do.

Since the type of stocks we were talking about above generally move inversely to their currency, the volatility in CHF is lower than in USD and therefore the stock becomes less "risky"! Typically Coca-Cola shows a volatility of only 9% in Swiss francs (while that of Novartis, which is considered to be a very defensive action, amounts to 10.77%).

Let's go further and look not only at volatility, but also at the protection that a security offers against dollar fluctuations. Using statistical tools, we can determine the link between the USD/CHF and the Swiss franc value of the stock in question, which we call the $risk. A value close to +1 indicates a very strong link, meaning that a fall in the greenback is usually accompanied by a fall in the CHF stock, hence a significant risk. It can also be used as leverage, if you want to play for example on the rise of both a US stock and the dollar. A value close to zero shows the absence of a relationship, and therefore that the value of the stock in CHF evolves in principle independently of the value of the USD. A value close to -1 is the sign of a strong inverse link, namely that a fall in the dollar is normally accompanied by a rise in the value of the stock in CHF, thus offering a blanket interesting against currency risk.

So a title like Dover shows virtually zero sensitivity to USD/CHF fluctuations, meaning the stock is hedging itself against exchange rate risk! Even stronger: Coca-Cola displays an inverse sensitivity of -0.58, McDonald's of -0.79 and Chevron of -0.54. These three securities can therefore a priori be used to cover other dollar positions that suffer when the greenback weakens. This is typically the case, for example, of Wal-Mart, Lowe's, Target And WalgreenThis is not surprising since the distribution sector sells imported goods in the US, which become more expensive as the dollar falls.

Of course, The value of a stock depends on multiple factors, and the variation of its currency relative to others is only one of the data in the equation. Thus, a significant change in the fundamentals of a security that would be used as a hedge against exchange rate risk could cause it to lose, at least partially, this particular virtue. For this reason, this strategy should be used on several securities, and in concert with the other methods already mentioned.

We have therefore seen that the exchange rate risk is not to be taken lightly, but that there are several solutions to protect against it. They do not all display the same degree of effectiveness, but they all make sense, the worst thing is to do nothing and let your portfolio depreciate with the exchange rate. Carefully selected local currency securities, a little Forex for those who are comfortable with this type of instrument and foreign currency securities that manage to free themselves from their own currency represent an ingenious and easy to implement combination.