According to Investopedia, Rebalancing is the process of realigning the weightings of a portfolio of assets. Rebalancing involves periodically buying or selling assets in a portfolio to maintain an original or desired level of asset allocation or risk.
Many international equity managers like to minimize the forex exposure of their equity portfolio and put on forex hedges to reduce that risk. Thus, at the end of each month they adjust the size of their hedges to bring them back into line with the current size of their portfolio.
What does this mean for the forex trader?
For the forex trader, the focus is on whether forex hedges need to be reduced or increased at month end. As a rule of thumb, if US stock prices increase during the month, short dollar hedges need to be increased (I.e. dollar selling) and vice versa if US equity prices fall during the month (I.e. dollar buying). Some adjust the hedges dynamically during the month and others do it on the last trading day of the month. Our focus is on the latter.
Let’s use a hypothetical example. Say a foreign fund manager is long $1 mln worth of US stocks at the end of February and fully hedges the forex risk by being short the equivalent US dollars vs. his base currency (e.g. the euro). Stocks rise sharply by 10% during March and the stock portfolio is valued at $1,100,000. This leaves the fund manager under-hedged by $100,000 so he has to sell that amount of dollars (e.g. vs. the euro) to fully hedge the forex risk.
How to use this knowledge to trade
In the above example, logic says, at a minimum, anticipation of dollar selling (due to the sharp rise in equities) should place be a limit on the dollar upside, especially the closer it gets to month end,. Vice versa would be the case if stocks fell sharply during the month.
Some traders will assume month end dollar demand or supply will be seen for rebalancing purposes. This knowledge can prove invaluable to forex traders although with a warning.
However, his is not an exact science as much depends on other news and trends, which could more than offset the impact of rebalancing flows.
Note, the key time of day at month end for rebalancing of forex hedges are completed by the 4 PM London fix. There will often be some erratic swings in prices leading upo to and around the 4 PM fix.
In any case, we are not privy to the actual flows so all we can do is assume rebalancing will lead to some dollar buying or selling depending on how equities performed during the month. As an outsider, all we can do is be on the lookout for any bouts of dollar buying or selling for month-end without knowing in advance which currencies will be in demand.
Please feel free to contact me with any questions or comments.
Jay Meisler
Co-founder Global-View.com
jay@global- view.com
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