Why Three-Month Rolling FX Forwards Can Hedge Long-Term Currency Exposure
Summary
The document explains how repeatedly renewing short-dated FX forwards can hedge a foreign-currency portfolio position even when the investment has no fixed exit date. The key mechanism is that a change in spot exchange rates creates gains or losses on the current forward; those gains or losses remain after the hedge is rolled into a new contract. This means the hedge can offset much of the currency movement over time, even though each individual forward only covers its own term.
The protection is incomplete when relative interest rates change, because the hedge does not lock in forward points beyond the current contract’s expiration. The discussion argues that rolling three-month contracts may be a practical cost and liquidity tradeoff: longer-dated forwards can be less liquid and more expensive, while futures-based interest-rate hedges add costs and margin requirements. It also notes that hedge size or timing may need adjustment as exposure changes. These are general explanations, not evidence that this tenor is optimal for every portfolio.
Key ideas
- Rolling forwards can retain gains or losses from spot-rate changes as the hedge is renewed.
- Short-dated rolls can hedge ongoing spot currency risk without knowing the investment’s exit date.
- Changes in relative interest rates can alter forward points beyond the current contract’s maturity.
- Longer-dated hedges may reduce some risks but can carry liquidity, transaction-cost, and margin disadvantages.
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Full text
# Why using 3 months forward to hedge fx risk on a fund of funds portfolio? # Why using 3 months forward to hedge fx risk on a fund of funds portfolio? In my previous job, a fund of funds, they used 3 months forward FX contracts (renewed every 3 months) to protect their portfolio against currency risk. If I do understand why forwards are useful for fixed schedule (like bonds with coupons at fixed periods). I don't understand why it is protecting the portfolio's positions against currencies risk during the undetermined positions lifetime time. Maybe, I'm unclear. So, here is an example: - The portfolio is in USD. - It has 3 positions, 2 in USD and 1 in EUR. - The EUR position needs to be protected against EUR/USD variation. - Positions can be held during an unknown period (over a year maybe). With renewed 3-months FX forward, your EUR position is protected only for 3 months. When the contract ends, you get a new one with a new "price" close to current spot and not close to the initial investment spot rate. Am I missing something? I was told, this is the most efficient way. ## Answer by RaveTheTadpole (score 12, accepted) https://quant.stackexchange.com/a/8244 The majority of the movement in currencies is in the spot rates, rather than in the term structure. A 3-month rolling hedge would always be protecting against movements in the spot rates, no matter when they happen. Using your example, if the current EUR/USD rate is 1.3333, you might be able to get a 3-month forward at 1.3339. (Forgive me if I have the direction wrong here, I haven't touched FX in years.) If the spot rate jumps to 1.2000 by the time your 3-month forward expires, you will have 0.1339 in profits to protect you from losses in your position. If you are then able to roll the hedge to a new 3-month forward at 1.2006, you still keep the 0.1339 in profits. When you finally exit you EUR position, you might only get 1.2000 for it, but you have 0.1339 in profits from that first forward. Therefore the hedge has worked, absorbing the vast majority of your currency losses. This rolling hedge would fail if the underlying were something where the term structure was more active. Take natural gas. If you have a natural gas position -- say a producing field that will come online in an unknown number of years into the future -- then making 3-month rolling hedges would not provide much protection. Natural gas in 3 months is very uncorrelated with natural gas in 3 years. To the extent that currency term structures do change -- meaning a move in the relative interest rates of the two countries -- you would not be protected very well. You would only be protected for the remaining life of the current 3-month forward, not for the months or years between that forward's expiration and your underlying position. Since your old employer says that 3-month rolling hedges were the most efficient, they probably did their research. Multi-year forwards are not nearly as liquid as 3-month forwards, and they would have paid a larger bid/offer to their bank/counterparty. In the USD/EUR case they could have used Eurodollars vs. Euribor futures to hedge the interest rate risk, but the transaction costs there are not low either, and they'd have to worry about margin. They probably decided that the risk was small and the cost of a more complete hedge was high. ## Answer by Andy Flury (score 0) https://quant.stackexchange.com/a/8267 The price of the Forex Future is linked to the Spot Rate by the following formula: ``` spot * exp(rate difference * years) ``` Choosing a 3-month time horizon is indeed quite common for "manual" hedging when the holding period of the positions is quite long. Yet the higher your trade frequency (in your case concerning the EUR position), the more often you need to adjust your hedge. If you have to do it on a daily basis (or even more frequently), it might make sense to use a Trading platform for this purpose. Two additional Notes on this topic: - There are actually three different contract sizes for the EUR/USD FX Futures: 2'500, 62'500 and 125'000 USD. We use the large ones to do the main portion of the hedge and mostly keep it for the entire 3 months. In addition we use the medium ones to adjust the hedge on a weekly basis - Also, some Brokers (e.g. InteractiveBrokers) provide virtual Spot Positions which essentially remove the when-to-roll question.
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