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Currency hedging takes off

By Peter V O'Brien

Friday 28th February 2003

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A leading derivatives broker has found sizeable interest in currency hedging from farmers acting as individuals.

OM Financial chief executive Colin Churchouse says there is "big interest" from farmers seeking to protect their returns in a time of volatile exchange rates and easing commodity prices.

He referred to beef farmers and compared their position to the situation early last year when beef prices in the US were relatively high and the New Zealand dollar was lower against the US currency.

Beef prices have retreated and the Kiwi dollar was worth 55.16USc on February 5, compared with 41.13USc at the end of November 2001, a rise of 34.1% in 14 months.

While farmers are rarely direct exporters, the use of currency hedging contracts can remove some of the volatility attached to returns for their produce paid out from the major exporters of unprocessed and/or processed farm output.

Mr Churchouse said his firm's business mix had changed in recent years: "We have expanded in foreign exchange."

Banks and institutions are the biggest individual operators in foreign exchange derivatives but Mr Churchouse said private client and corporate business in total was larger.

People were using OM Financial's "margin foreign exchange" product, as well as standard hedging, for hedging and/or speculation, depending on their requirements. He said people and corporates should lock in 50% or more of their future offshore cashflows in foreign exchange products.

OM Financial's margin foreign exchange facility gives investors access to a global, 24-hour interbank foreign exchange market. A relatively small initial margin allows an investor to control a position much bigger than the deposited margin.

Leverage is again the key factor in this derivative. The initial margin is fixed on a daily basis with reference to the volatility of each currency traded in the facility.

It varies from a minimum of 2% of the position's face value. Mr Churchouse said it was in the 3-5% range, understandable figures given the recent movement in currencies, particularly the US dollar. It was in the 2.5-3.5% range four years ago.

The initial margin maintains each position the investor enters and its amount depends on market volatility at any time.

There is the usual risk associated with leverage when using margin foreign exchange.

Volatile markets mean the investor can go from a winning position to a losing one in a short period and small changes in a currency translate into a large movement in the total position. The daily calculation of unrealised "profits" or "losses" means an investor can be called on for additional margin if the unrealised loss partially or totally wiped out the initial margin.

Extra margin restores the initial figure to the necessary amount.

Margin calls could continue if unrealised losses mounted and an investor might put in substantially more than the first margin until the loss is realised when the position is closed out.

Margin foreign exchange is not suitable for all investors. Each should consider whether it fits into his currency hedging needs.

New Zealand investors are involved in derivatives overseas in many areas, including commodities, equities, stock exchange indices and currencies. Some are speculators while others want to protect existing physical positions. The latter could be using derivatives for portfolio protection, cashflow management, arbitrage (capitalising on different prices in two or more markets) and asset allocation.

Speculators usually have no interest in such techniques, being in the game for a quick dollar, although they are likely to be aware of the possibility of a quick loss.

A decision to use derivatives requires a careful assessment of risk tolerance. Profits can be large for a small layout but market volatility can result in the complete loss of the layout.

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