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Foreign exchange risk: investing in turbos

1 July 2018, WEALTHEON

A turbo is a product which offers investors the possibility of exploiting leverage among a variety of underlying assets such as indices, equities, bonds, commodities and currencies.

With turbos, you can speculate on the upside or the downside. Long turbos increase in value when the underlying assets rise, whereas short turbos increase in value when the underlying assets fall and vice-versa in both cases.

By buying a long turbo, the bank is generally buying into the underlying asset. Part of the cost of the underlying asset is financed by the bank, while the balance is paid by the investor in the form of the value of the long turbo. Investors also pay interest on the proportion financed by the bank. This is why it is in the interest of banks to issue turbos. If the value of the underlying asset increases, the value of the long turbo increases more rapidly. On the other hand, if the value of the underlying asset falls, the value of the long turbo falls more rapidly. The bank’s investment is therefore also potentially jeopardised. For this reason, banks include security mechanism within the turbos, in the form of an integrated stop-loss trigger.

A stop-loss order is a sell order in an investment, or a buy order in the case of a short turbo, which is triggered as soon as the price of the underlying asset breaches a predetermined price, on the downside for long turbos and on the upside for short turbos. The sale of the investment is executed through an order with instructions to execute at-best price, i.e. at the best price available in the market. This mechanism is also advantageous for investors, as the execution of stop-loss orders guarantees that no more than the investment will ever be lost. When the price of an underlying asset is particularly volatile, for example, if an opening price is marked heavily lower due to a company earnings downgrade, losses beyond the level of financing are supported by the bank. Investors therefore will never again hear of a balance remaining due. If a long turbo is sold at a higher price than the level of financing, the bank pays the surplus (capital gain) to investors after a few days.

Hedging foreign exchange risk in your portfolio 

Imagine you own a portfolio managed in euros but containing investments denominated in US dollars and you are expecting the US dollar to depreciate against the euro. In order to protect your portfolio, i.e. to hedge it, against foreign exchange risk, you can use a long turbo on the EUR/USD exchange rate. The value of this turbo will increase if the euro appreciates against the dollar and therefore compensate the fall in the value in euros of your investments in US dollars. 

Example

To illustrate the number of turbos necessary to hedge against the foreign exchange risk of a portfolio, let us consider a sample portfolio worth USD 100,000.

To hedge the risk incurred by the US dollars, you have the choice between different long turbos. When you opt for a turbo with a lower stop-loss threshold, your initial investment will be higher. The lower the stop-loss threshold, the more the dollar can appreciate before your turbo is liquidated, which will leave your position in US dollars unhedged. 

In this example, we are using a sample EUR/USD long turbo with a level of financing of 1.20 and a starting EUR/USD exchange rate at 1.35. 

Table 1: initial situation

The number of long turbos necessary to hedge the portfolio against a fall in the US dollar is calculated as follows: 

The theoretical value of the turbo is:

The amount you invest to hedge your position is calculated by multiplying the number of turbos required by the value of the turbo. The investment required to hedge the foreign exchange risk of this portfolio is 833 x 11.11 = EUR 9,255. The initial situation of this portfolio will therefore be presented as follows:

Scenario 1: the US dollars falls 

What happens if the EUR/USD exchange rate moves from 1.35 to 1.40 after one month? 

The theoretical value of the turbo after one month is: 

Table 2: scenario 1 - the US dollar falls

The increase in value of the turbo position is EUR 2,465. The fall in value of your position in US dollars is EUR 2,645. The increase in value of the turbo position largely compensates the fall in the value in euros of your position in US dollars. The difference in the change in values is due to the increase in the level of financing, to which the financing costs are charged on a daily basis. 

Scenario 2: the US dollar rallies

What happens if the EUR/USD exchange rate moves from 1.35 to 1.30 after one month? 

The theoretical value of the turbo after one month is: 

Table 3: scenario 2 - the US dollar rallies

The fall in value of the turbo position is EUR 3,045. The increase in value of your position in US dollars is EUR 2,849. Once again, the difference in the change in values is due to the increase in the level of financing, to which the financing costs are charged on a daily basis. In this example, you pay around EUR 192 of financing costs to hedge USD 100,000 during one month. 

Currency turbos financing costs 

Financing costs on long turbos are charged to the level of financing. In the case of currency turbos, you are affected by 2 rates. For the level of financing of a long turbo on the EUR/USD exchange rate, you pay the US overnight rate and you receive the European overnight rate. NB: financing costs differ between underlying assets and depend on real rates. This may incur relatively high costs, for example for long turbos on the EUR/TRY exchange rate. You also always pay a 2% margin.
 

Stop-loss threshold

If, contrary to your expectations, the US dollar appreciates, there is then a chance that your long turbo will reach its stop-loss threshold and your foreign exchange risk will no longer be hedged. If you see the exchange rate moving too close to your stop-loss threshold, you can refinance your position with a new long turbo which has a lower stop-loss threshold. Refinancing involves selling turbos in a given underlying asset and rolling the proceeds directly into buying other turbos in the same underlying asset. You can refinance towards a long turbo with a lower stop-loss threshold if the exchange rate falls, or you can also refinance into a turbo with a higher stop-loss threshold when the exchange rate increases. Always bear in mind however that currency turbo stop-loss thresholds are adapted on the 15th of the month, based on the level of financing at that date.

Risks

Currency turbos may calculate their stop-loss threshold around the clock. The calculation may therefore take place outside of normal trading session hours. Turbo prices may fluctuate sharply and they are therefore highly volatile.

 


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