The Portfolio is the Hedge

03.29.2016 By

From our latest discussion paper

Stanislav, now an analyst on our Canadian equity team, was fifteen when his family decided to move from Kazakhstan to Russia. A tall, thin boy with dark hair and a focused expression, he belonged to a family of Russian restauranteurs.

Growing up in post-Soviet Kazakhstan and later Russia, Stanislav received an education in money that would seem alien to North American children. As a child, he overheard stories of shortages in currency, rapid inflation and people’s savings becoming worthless overnight due to valuation. It was not uncommon where he lived for people to buy electronics and food (whatever was available) as soon as they were paid because no one wanted to risk keeping it in savings. Few trusted that money would keep its worth in the future…because it rarely did.

As Stanislav recounts in one story:

“I remember that my family never played the lottery but one time my mother did and she won, to our surprise.

The crazy part was that the amount printed on the ticket was meant to be a big sum, enough to buy a refrigerator, but since it coincided with a period of rapid devaluation, the ticket became almost worthless by the time my mother received it.

She said it was not even worth the trouble to cash it in because of its meager value and the trouble of doing so.”

Imagine winning the lottery and not even bothering to cash it in because it wouldn’t be worth your time! That’s quick erosion of purchasing power.

Currencies play a major role in our lives. They impact what and how much we can buy, how we think about savings, and even where we go on vacation. Currencies impact us day-to-day and over the long run. And as the experience of post-Soviet Russia illustrates, they can have a big impact on our lives at times.

Unfortunately, the topic of currency is also one in which there is a great deal of confusion and indifference. Many people think about currency risk about as often as they do their appendix, i.e., never, unless there is a problem. And even those who do care about currency risk often struggle to wrap their heads around the topic given its complexity.

However, currency risk is important enough that everyone should have some understanding of it. It is important to know what it is, the ways it can impact us, and what, if anything, we can do about it.

 

Read the full discussion paper here.

 

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1 Comment

  • Reply
    Shiv Desai
    04.01.2016 at 10:40 am

    Thanks for sharing such an informative article but I think the hedging could have been described more accurately. It’s mentioned that “In a hedge, the buyer pays a fee for the right to lock-in at a price they can buy or sell at a future date. The seller of the hedge takes the risk of the price movement.” Later when explaining forward contract it is mentioned that, “And you’ll pay a fee for this contract. This is why a hedge, in its simplest form, is also like an insurance policy. You pay a premium today to lock in a price.”

    First hedge, in its purest form, future/forward contract doesn’t give right to either of the parties as it is a binding contract for both parties. Options provides a right to the buyer and imposes an obligation to the seller. Also, there is no upfront fees that the buyer has to pay to seller to enter into a future/forward contract. That’s the reason the fair value of the contract at the inception is zero for both parties. Whereas, option buyer needs to pay the premium to the seller. Also, option contract, rather than hedge contract works like an insurance policy whose pay-off from the underwriter is contingent on the future adverse effect. In hedge, there will always be one party paying the other at the time of expiration. Where as in insurance, such as option contract, the underwriter (option seller) only needs to pay the buyer in case of unfavorable price changes.

    Am I missing the point? Apart from this technicality, I totally agree with the spirit of the article and logic.

    Thanks,
    Shiv Desai

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