Question

Please give an example of the similarity between hedging currency risk and the cash and carry model.

Answer 1

International investing and trade has one unintended consequence; namely, the creation of currency risk which causes the local currency value of the foreign receivables or investments to fluctuate dramatically because of pure currency movements. Currency risk is the bane of foreign investment and trade, as trading products or assets in foreign countries automatically creates exposure to foreign currencies, which left unmanaged can hurt returns. Hence, typical recommendations include either that companies and investors should remove this uncompensated volatility by naivelyhedging back into the base currency.

A cash-and-carry trade is a trading strategy in which an investor holds a long position in a security or commodity while simultaneously selling it – specifically, by holding a short position in a futures contract on the same security or commodity. A cash-and-carry trade has several steps. The investor must first purchase a security or commodity. He or she then sells a futures contract for that same security or commodity. He holds or "carries" that security or commodity until the futures contract expires. When it does, the investor delivers the commodity or security he previously bought. By selling a futures contract, the investor has taken a short position, and knows how much will be made on the delivery date and the cost of the security because of the cash-and-carry trade’s long position component. Investors use this arbitrage strategy when the current cost of buying a security or commodity, plus its cost of carry, is less than how much the security or commodity can be sold for in the future. In other words, the investor believes the securities are mispriced at the present time, and that he can profit by their eventual correction.

In another sense, both hedging and cash & carry are to mean to hedge & protect from currency risk.