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Diminishing returns: Hedging dollars with a dollar-denominated index

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  • Sun, Mar 22, 2009 - 05:04am

    #1

    Erik T.

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    Diminishing returns: Hedging dollars with a dollar-denominated index

Like many active traders on this site, I’m short the U.S. Dollar Index. But the more I try to get my head around the math, the more I realize the inherent flaw of this trade when large changes in the index are contemplated.

To illustrate my point, consider the extreme case: An investor who sells one DX contract for its current price of $84,000.00. His intention is to hedge future weakness in the currency. If the DX falls all the way to zero, the investor will see a windfall of the maximum possible payout: $84,000. And those 84,000 dollars will be worth exactly zero, since what was being measured by the underlying index was the value of dollars! So in the normal "best case" the investor gets nothing in exchange for taking the risk of the DX going up, which would not only cost him some $, but cost him some $ that are worth more than current $!

Ok, a collapse to zero isn’t plausible you say. But many of us on this site fear that a collapse to half the current level is possible if our government keeps up its current mischief. So the DX falls to 42, and our hypothetical investor can sell his single contract for a "profit" of $42,000. But those 42,000 dollars are worth only $21,000 in current-value dollars. So he took a chance of loosing more than that if the DX rose to 100 (possible in the short term if safety trades force a whole lot of sudden dollar buying), and even in the fairly extreme case of a 50% collapse, he only made 25% in debasement-adjusted terms.

True, he could fully hedge his downside and protect all of his wealth by employing the leverage made possible by the futures and options markets, but to do that he’d have to sell two contracts in order to come out even in terms of purchasing power in a 50% debasement, and he could loose 50%+ of his purchasing power in an up-move of much less dramatic scale.

Am I missing something? Suddenly one of my favorite trades (short the DX) seems like a fool’s errand. Obviously the solution would be to trade DX contracts denominated in something other than dollars, but no such contract exists to my knowledge.

Obviously, going long precious metals would be an alternative to the short DX trade, but it’s really not a direct play on the dollar itself. Is there a better way to hedge a dollar decline that I’m not seeing?

Thanks,

Erik

 

  • Sun, Mar 22, 2009 - 06:32am

    #2
    Peak Prosperity Admin

    Peak Prosperity Admin

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    Re: Diminishing returns: Hedging dollars with a …

Buy up the right proportion of Yen, Assie Dollars, Canadian Dollars, Euros, Francs and so on.

  • Sun, Mar 22, 2009 - 06:44am

    #3
    Peak Prosperity Admin

    Peak Prosperity Admin

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    Re: Diminishing returns: Hedging dollars with a …

Sorry LYS, but that doesn’t work. All the other governments are engaging in what used to be called competitive devaluation in order to protect their export businesses. The intelligent trade would be to hedge by buying a strong currency, but there are none left!

Erik

 

  • Sun, Mar 22, 2009 - 07:54pm

    #4
    Peak Prosperity Admin

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    Totally, Erik T., but . . .

Totally, Erik, I get that the other currencies suck.  But isn’t the US Dollar Index just a measure of the dollar vs. a basket of other currencies?  So if you are short the US Dollar Index, aren’t you just long the other currencies?  That seems like a major flaw in going short the US Dollar Index in-and-of-itself, let alone what you describe.  The US dollar can suck, but if the other currencies suck worse on whatever basis they’re weighted in the index, then the index goes up even as the value of the dollar falls relative to commodities or PMs. Am I right?

I thought that’s what you wanted — to short the dollar relative to other currencies.  If that’s not what you wnat, and you are looking for an anti-dollar play that is not also subject to the other currencies sucking, then you need to be long PMs.  I don’t see an alternative.

What am I missing?

  • Sun, Mar 22, 2009 - 09:07pm

    #5
    Peak Prosperity Admin

    Peak Prosperity Admin

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    Re: Diminishing returns: Hedging dollars with a …

Hey LYS,

The problem is that (for now, while we’re still the de-facto reserve currency) all futures contracts are settled in dollars. So whether it’s short the DX or long a basket of FOREX, any gains on a short-dollar bet get paid back in watered down dollars.

Don’t worry, I’m already long PMs and will increase those positions considerably as soon as we see some softness. But that’s really a different trade than short the dollar. Yes, they are closely related, but they are different trades.

I think my conclusion is that because all the contracts are settled in dollars, there is just an inherent defect in the short-DX trade, and I should probably underweight that trade in favor of putting more capital into long PM positions. One could even argue that to a lesser extent, the short long-bond trade suffers the same problem as the short DX trade: The reason many of us expect the short long-bond trade to be profitable is that long bond values have to collapse as the currency collapses and foreign capital runs for the hills. Those of us with large shorts on long bonds will receive a windfall… Of watered down dollars.

If only there were gold-settled futures contracts!

Erik

 

  • Sun, Mar 22, 2009 - 09:10pm

    #6
    Peak Prosperity Admin

    Peak Prosperity Admin

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    Re: Diminishing returns: Hedging dollars with a …

You need to be a supermodel to be paid in gold, Erik.

 

SG

 

 

  • Sun, Mar 22, 2009 - 09:18pm

    #7
    Peak Prosperity Admin

    Peak Prosperity Admin

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    Re: Diminishing returns: Hedging dollars with a …

Then how about this for an anti-dollar trade Erik:

Mortgage everything in site.

Then you can make some real use of watered-down dollars coming back to you.

Yes? No?

  • Wed, May 06, 2009 - 10:45pm

    #8
    Peak Prosperity Admin

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    Re: Diminishing returns: Hedging dollars with a …

Why not hedge with physical precious metals (gold and silver), or maybe even copper (on the logic that in a total collapse and reversion to a much more basic society and lifestyle, copper would still be useful and needed for many things)?

John F.

  • Wed, Jun 03, 2009 - 12:16am

    #9
    Peak Prosperity Admin

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    Re: Diminishing returns: Hedging dollars with a …

[quote=ErikTownsend]

Sorry LYS, but that doesn’t work. All the other governments are engaging in what used to be called competitive devaluation in order to protect their export businesses. The intelligent trade would be to hedge by buying a strong currency, but there are none left!

Erik

 

[/quote]

You are probably right, in the long term, but I have the feeling that in the next year Australia, Canada and other commodity rich nations could see their currencies double in strength, against the dollar, from where they are now, even if they do major quantitative easing. This is my worst nightmare as Iive in Canada but my income comes from the US. So I’ve hedged in Canadian cash and gold bullion.

  • Wed, Jun 03, 2009 - 12:37am

    #10
    Peak Prosperity Admin

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    Re: Diminishing returns: Hedging dollars with a …

edited for sheer redundancy

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