Proxy Hedging

BY: GROUP 5
GROUP MEMBERS(HASC)

 ALOISIA PANASHE KUFAKUNESU(R184538J)

 CHARITY CHIFAMBA(R181684G)
 PRIVILEDGE TSVURU(R181696V)
 LOUIS MASUKUSA(R181704X)
 LEEMAN GUNZO(R181693A)
 PADDINGTON NDLOVU(R181679C)
 TRISH CHISVO(R181699G)
 LAWRENCE CHATINDAIRA(R169191H)
 EMMANUEL MUSHAYI(R184089G)
 FARAI MUZAVAZI(R181678H)
 TENDAI MUKURA(R181709H)
What is proxy hedging?

 Is a strategy that introduces basis risk intentionally. Groups of currencies such as those
within regional areas may sometimes exhibit high correlation to one another which may
be due to similar economic or political prospects or highly regional trade and often
involves emerging markets.
 It is the use of a price or rate correlated financial instrument to hedge a particular risk
when a direct hedge for that risk is not available.
 Common proxy hedges are the use of one currency which is in concert with another to
hedge the risk in another currency.
How proxy hedging works?

 Proxy hedging is effectively the technique that consists of finding the right currency or
currencies to minimize the basis risk.
 Hedging with a proxy requires finding the right currency and being able to monitor and
account that hedge.
 Finding the right currency is done based on the following sectorial knowledge.
 There is need for knowledge on economic performance, exchange rates, interest rates and
inflation and also political stability in the country.
 For successful proxy hedging the company should have quality time series data on
exchange rate in order to make predictions if the currency is stable in the future.
Proxy hedging
Advantages
 Successful proxy hedging gives the trader
protection against inflation, currency
exchange rate changes and interest rate
changes.
 Improves planning capability of the firm since
they focus on their core business.
 company can enhance its competitive position
by selecting a generally acceptable currency
for the industry.
Disadvantages
 Proxy hedging involves cost that can eat up
profits.
 Risk and reward are usually proportional one
another thus reducing risk means reducing profits,
 Data used for cost effective proxy hedge can be of
poor quality thus affecting currency selection.
 Proxy hedging strategies is difficult to follow for
short term traders.
Example

 An Japanese Asset Manager holds some USD assets and wants to hedge the resulting foreign exchange
exposure
 The current interest rate differential between USD and home currency (5.25% against 1.50%) implies a
high cost of hedging this position.
 A potential solution to mitigate the cost of the carry on the hedge is to hedge the underlying exposure
with a proxy . Unfortunately the hedger bears the risk that the variations on the proxy do not offset the
variations of the underlying FX exposure.
 The manager can choose single currency proxies where a derivative in a third currency pair is entered to
hedge the underlying exposure or proxy baskets where a portfolio of forwards or a basket option can be
used to hedge a single currency exposure.
 If there is strong correlation between the Japanese yen and the USD then a proxy currency is selected in
place of the two currencies
Proxy Hedging
Factors for
 An organisation may find it difficult to obtain fair
pricing on a particular currency if there is not a
highly competitive market for the currency.
 An organisation might have exposure to several
related currencies ,each of which are too small for an
effective hedging program.
 There might be insignificant regional effects on
individual currencies .
 Currency hedging products for the particular
currency of exposure may not be available.
Factors against
 The currency selection criteria is based on correlation
of the currencies which is usually historical data hence
future exchange rate cannot be forecast with accuracy .
 Domestic factors ,such as political instability can
dramatically affect country’s exchange rate.
 There is no guarantee that historical correlation is
going to have a relationship with future correlation.
 Ultimately a proxy hedge could result in an
organisation being unhedged , under-hedges or over-
hedged
Thank you
THE END