How would you hedge your life?

Howdy folks,

It's been a while since I've posted in here. Some news for me is that I now work for a foreign exchange risk management company that has a software which helps companies discover where they are exposed to foreign exchange risk. The process of multi-national companies hedging is very interesting, and a little different than how a speculative hedger/carry trader thinks of hedging.

Say a company receives a 10 million dollar contract to build a bridge in another country. The bridge construction could take several years to complete, and the currencies involved in the transaction could change in value drastically in that time.

Now here is how I believe the hedge works. Say the construction firm is US based and the buyer is in Germany. There are two currencies, the functional and the transactional currencies. The functional currency would be USD since that is what the construction company reports in. The transactional currency would be EUR because that is what the German buyer will pay in. If I understand correctly, the contract would then be signed for the transaction amount.

For hypothetical reasons we'll say the exchange rate of EUR:USD is 1:1. Ok so the contract is for 10 million EUR to build the bridge. The buyer is going to pay 10 million Euros at the completion of construction. Now say the dollar appreciates (hypothetical) by the time the bridge is completed to where the ratio is now 2:1. So now when the german buyer pays 10 million euro, the construction company only gets the equivalent in USD or 5 million USD. This would be reported as a loss on their balance sheet since they expected to get 10 million, but only got 5 million.

So what does the construction company do? They make a trade at the signing of the original contract that will offset any gains or losses they may incur in FX translation. In this case their trade would have made them 5 million dollars so that total FX gain/loss is zero.

I'm having a little trouble wrapping my head how this would work for someone on a personal level. Here's what I want to do. I want to completely remove all FX risk from my personal wealth. For example, say the price of a car from germany (I live in the US) is worth $10,000 today. In 3 years it might cost me $15,000 if the dollar depreciates. To me I don't like the idea that my similar work output gets me less bang for my buck in the future. I want the spending power of my personal savings to remain equal for the rest of my life.

How would I go about doing that? If we go into a recession that would mean my savings would automatically grow to a large amount. During expansion my personal savings would drop in dollar value. What instruments can I use to place hedges against this value appreciation and depreciation? Placing a trade on forex wouldn't really do the trick would it? Or would it involve placing a proportionate amount of money and short selling the dollar against another large economy currency like GBP or euro?

This question is getting really long. I think you guys know where I'm trying to go with this.

i once think about it, but with no decent answer to use it
http://www.forexfactory.com/showthread.php?t=28080

This line of thought has crosed my mind too, however, I don't know of a way to do it. With some brokers you can just buy and sell the same currency at the same time, thus eliminating risk of inflation or deflation between those 2 currencies. You have to subtract spread and any interest that is charged, although in theory the interest should even out as well.

Hedging works great in a situation between 2 currencies like you mentioned. However, hedging against any and all inflation is probably difficult, I don't know how. You may hedge against the euro but not against the pound for example, and your currency could still loose value against the pound if both the euro and the usd fell against the pound.

buy and sell the same currency at the same time doensnt work anymore..
All people that trade with hedge is very surprised with last rates..
my clue is a 3 pairs..


Best Regards,
Marcelo Marques

This is a typical example for derivatives like Interest-Rate-Swaps.

When I used to workf for investment houses, very often the banks came up to buy or sell a taylored swap since they were backing a company with a foreign currency loan based on a business transaction like the one you mentioned as an example. Most of the time its the buyer of the goods who has to cater for the risk - not the provider of the service; although there are exceptions.

All the type of transaction are "off balance sheet", meaning the underlying capital does not change hands - only the difference in (exchange) rates over time will be paid by one ot the other party.

regards
daytrading

Your personal hedge against currency rate change would depend on what you're planning to do with your dollars.

Are you going to buy a German car in the future? If you think the dollar will depreciate against the euro, then you should buy your euros now and "lock in" the price of that car. If the car costs 10K USD now, then buy a mini contract for the E/U. Whatever extra you will have to pay for the car at some point in the future will be offset by gains in the forex trade.

If you aren't sure what the dollar was going to do in the future, and wanted to hedge regardless, then again, buy the euros. If the dollar appreciates, your trade will lose, but you will get the car for fewer dollars.

This might be easier to understand in terms of commodities. Let's say I own a trucking company. I have contracts into the future for a certain amount of trucking miles. I know if fuel goes up I will get hit, so I buy fuel futures such that whatever I lose by paying more for the fuel than I counted on, I will make on the contracts. If fuel goes down I will lose on the contracts, but I'm even because I'll be paying less for all that fuel I will use. Therefore I make my projected profit regardless of change in fuel price. That would be a true "hedge".

Unless you're planning to spend your money overseas, perhaps "hedge" isn't the correct term. If you're trying to keep up with inflation, put the money in your favorite investments. Stocks and real estate look pretty cheap right now!

So I guess the answer to "how would you hedge your life" is, "invest". I'm not satisfied with hedging, I want to make a good return and achieve growth well above inflation rates.