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(54) SYSTEM AND METHOD FOR HEDGING W0 WO 00/30053 * 5/2000 AGAINST FOREIGN EXCHANGE RISK. Nusbam, David Trading the Wide World of foreign

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(12) United States Patent Gerhard US B1 (10) Patent N0.: (45) Date of Patent: Oct. 4, 2005 (54) SYSTEM AND METHOD FOR HEDGING W0 WO 00/30053 * 5/2000 AGAINST FOREIGN EXCHANGE RISK ASSoCIATED WITH
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(12) United States Patent Gerhard US B1 (10) Patent N0.: (45) Date of Patent: Oct. 4, 2005 (54) SYSTEM AND METHOD FOR HEDGING W0 WO 00/30053 * 5/2000 AGAINST FOREIGN EXCHANGE RISK ASSoCIATED WITH SECURITIES OTHER PUBLICATIONS TRANSACTIONS Nusbam, David Trading the Wide World of foreign (75) _ Inventor - - Meler Gerhard Stemhausen (CH) exchange, Futures (Cedar Falls, Iowa), v24, n4, p624(4), Apr. 1995, Dialog?le 14s, Accession No * (73) Assigneej UBS AG (CH) Hedging Currency Risks Dynamic Hedging Strategies Based on O & A Trading Models by Ulrich A. Muller, ( * ) Notice: Subject to any disclaimer, the term of this Jun. 28, 1995, 11 pages. patent is extended or adjusted under 35 U.S.C. 4(b) by 524 days. * Cited (21) APPL No: 09/689,242 Primary Examiner FrantZy Poinvil (74) Attorney, Agent, or Firm Proskauer Rose LLP (22) Filed: Oct. 11, 2000 (57) ABSTRACT (51) Int. Cl G06F 17/60 (52) US. Cl /37; 705/36; 705/44 A method for hedging an investor against a Currency risk (58) Field of Search /37, 36, 46, 705/4 associated With a purchase of a Security having a Value the investor having purchased the security in a foreign currency and the investor desiring to receive the proceeds from a sale (56) References Cited of the security in a home currency. The foreign currency and home currency have an exchange rate at the time of the Us PATENT DOCUMENTS purchase and an exchange rate at the time of the sale. The A 9/1997 Turk /239 method includes the Steps of receiving a request for hedging 5:884j274 A * 3/1999 Walker et al 705/4 against the currency risk for a time period. Next, a cost is 5,897,621 A 4/1999 Boesch et a1 705/26 calculated for hedging against the currency risk based on the 5,903,882 A * 5/1999 Asay et a1, 705/44 foreign currency, the home currency, the exchange rate at the 5,963,923 A * 10/1999 Garber /37 time of the purchase, the value and the time period. Next, the 6,016,483 A * 1/2000 Rickard et a1 705/37 investor is provided With the proceeds from the sale based on A 4/2000 Gottesman et a1- ~~~~~~~~~ 705/35 the exchange rate at the time of the sale if the exchange rate 6,092,056 A : 7/2000 Tull 6% a1 705/35 at the time of the sale is greater than the exchange rate at the * gigglggnsetegfl'uz: time of the purchase. Finally, the investor is provided With B1 * 11/2001 Lange ~~~~~~~~~~~~~~ n the proceeds from the sale based on the exchange rate at the 6:347j307 B1 * 2/2002 Sandhu et al 705/35 time of the purchase if the exchange rate at the time of the 2002/ A1 * 10/2002 Lange /35 Purchase is greater than Of equal to the exchahge rate at the time of the sale. FOREIGN PATENT DOCUMENTS EP A2 6/ Claims, 3 Drawing Sheets SECURITIES EXCHANGE 5,_/ FX DATA T5333; H 238$? SOURCE g USER j \13 \7 4 We /\ 9 \ 1/ TRADING STATION U.S. Patent 0a. 4, 2005 Sheet 1 0f 3 5 SECURITIES EXCHANGE TRADING ENGINE PRICING ENGINE FX DATA SOURCE f 11 USER INTERFACE MODULE I 7 E TRADING STATION FIG. 1 U.S. Patent Oct. 4,2005 Sheet 2 of3 INVESTOR ENTERS ORDER STEP 1 STEP 2 EXECUTE ORDER WITHOUT INSURANCE STEP 5 WATCH LIMIT ORDER FILLED EXECUTE -_- (UNFILLED) ORDER ORDER STEP 8 YES PARTIAL FILL.2 STEP 6 NO BOOK AND SETTLE STEP 7 TRANSACTION FIG. 2 U.S. Patent 0a. 4,2005 Sheet 3 Ora STEP 9 SELECT HEDGE TIME PERIOD STEP 10 CALCULATE HEDGECOST YES STEP 11 WANT TO PURCHASE? SELECT DIFF. TIME PERIOD? STEP 13 STEP l2 ESTABLISHING HEDGE PQLMY STEP 14 NO HEDGE PURCHASED FIG. 3 1 SYSTEM AND METHOD FOR HEDGING AGAINST FOREIGN EXCHANGE RISK ASSOCIATED WITH SECURITIES TRANSACTIONS BACKGROUND The following invention relates to a method and system for hedging against the risk of?uctuations in foreign exchange rates and, in particular, for providing a hedge against foreign exchange risk associated With security trans actions. There has been a rapid increase in the number of securities of foreign companies that are traded in the US.?nancial markets, such as the NeW York Stock Exchange, the Ameri can Stock Exchange, NASDAQ and the over-the- counter markets. In addition, there has been an increasing interest on the part of US. investors regarding securities traded on foreign markets. These trends demonstrate a shift to a global cross-border trading network in Which investors can trade in foreign securities as easily as trading in domestic securities. A potential impediment to the establishment of a global trading network is that investors that trade in instruments in currencies other than their home currency Will be exposed to the risks associated With the change in foreign exchange rates. For example, if a Japanese investors purchases 100 shares of XYZ corp. trading on the NASDAQ for $10 a share, the transaction Would cost the investor 100,000 yen, assuming the exchange rate Was 100 yen to the dollar at the time of the transaction. If the investor decides to sell the XYZ shares at a time When the exchange rate is 95 yen to the dollar, the investor Would incur a 5% loss associated With the?uctuation in the foreign exchange rate. This added risk may deter an investor from trading in a foreign security. There are existing techniques for protecting against the?uctuation of foreign exchange risks. For example, a buyer of an FX call option has right to purchase a speci?ed amount of foreign currency at a speci?ed exchange rate at a speci?ed time. By purchasing an FX option for the currency the investor Wishes to receive upon selling the foreign security, the investor can minimize the risk associated With the?uctuation of that currency. FX options, however, are unsuitable for providing insur ance against foreign exchange risks associated With a secu rity transaction for several reasons. First, the use of FX options Would add a layer of complexity to the security transaction by requiring the investor to be familiar With option investing and the use of calls and puts to hedge a position. Also, FX options are typically for?xed amounts of currency, for eg $100,000, and do not generally match the amount of currency risk associated With a typical securities transaction (in Which the average order size in securities transaction is $,000). Furthermore, the strike prices of FX options for a particular currency pair are prede?ned by the foreign exchange market makers and Will often not match the exact exchange rate at Which a speci?c securities trans action took place. In addition, FX option are normally European style in Which case the premium does not strictly follow the exchange rate movements so that only partial FX risk protection is achieved. Also, European style options can only be exercised at expiry so they are not useful for protecting a speci?c equity position that may be termi nated by the investor at any time. Finally, FX options are not easily purchased on-line so that equity investors Will have to undergo a potentially time consuming process to hedge the FX risk associated With their foreign equity investment Another technique of hedging FX risks is the purchase of currency certi?cates. Currency certi?cates, however, also suffer from some of the same drawbacks as FX options including the introduction of added complexity to the secu rities transaction, standard certi?cate amounts that do not match the size of the hedge needed and prede?ned strike levels that do not match the exchange rate of the particular securities transaction. A method for generating and executing an insurance policy for foreign exchange losses is disclosed in US. Pat. No. 5,884,274 (the 274 patent ). The 274 patent teaches a method by Which individual travelers can lock in favorable exchange rates for a particular foreign currency thereby eliminating the need to either purchase the foreign currency or an instrument denominated in the foreign currency, such as traveler s checks. Under the method of the 274 patent, an insurance policy is provided to the traveler based on the traveler s preferences including a speci?ed currency, the amount of coverage and the period of coverage. The method then calculates the premium cost of the insurance policy based on the current exchange pair as Well as an estimate of the volatility of the currency. Once the traveler purchases the foreign exchange policy for a particular exchange rate, that exchange rate is locked in for the amount of time and coverage speci?ed in the policy. Thus, When the traveler makes a purchase in the foreign currency using a credit card, the exchange rate at the time of the purchase is compared to the exchange rate of the insurance policy to determine if the traveler is entitled to foreign exchange adjustment. Similarly, insurance coverage may be provided When the traveler WithdraWs the foreign currency from an ATM or from a bank. Although the 274 patent discloses providing individuals an insurance policy against foreign exchange loss for a desired currency amount and for a desired period of time, the 274 patent does not teach a method for providing a hedge to investors against foreign exchange risks associated With the purchase of?nancial instruments, such as equity securities, in currencies other than their home currency. Furthermore, the method disclosed in 274 patent is not suitable for providing a hedge against foreign exchange losses associated With trading foreign equity securities. First, in the 274 patent, once the purchased coverage amount speci?ed by the insurance policy is exceeded, the traveler is no longer protected against currency?uctuations. With respect to a purchase of an equity instrument, however, such a limitation in coverage amount is undesirable because the amount of coverage required fully to hedge against FX losses may increase in the event the security appreciates. Also, the insurance coverage provided by the method of the 274 patent is limited to the coverage period speci?ed in the policy after Which time the traveler s purchases are not covered. For a traveler Wishing FX risk protection, such a limitation is not especially problematic because the traveler can generally specify a coverage period tied to a planned travel schedule. In contrast, investors in?nancial instru ments cannot predict at What time in the future they Will exit a particular position so a policy With a?xed coverage period Will not be particularly useful. Accordingly, it is desirable to provide a method and system by Which investors that trade in?nancial instruments in foreign currencies can easily purchase a hedge against the foreign exchange risk associated With a particular trade. SUMMARY OF THE INVENTION The present invention is directed to overcoming the drawbacks of the prior art. Under the present invention, a 3 system and method is provided for hedging an investor against a currency risk associated With a purchase of a security having a value, the investor having purchased the security in a foreign currency and the investor desiring to receive the proceeds from a sale of the security in a home currency. The foreign currency and home currency have an exchange rate at the time of the purchase and an exchange rate at the time of the sale. The method includes the steps of receiving a request for hedging against the currency risk for a time period. Next, a cost is calculated for hedging against the currency risk based on the foreign currency, the home currency, the exchange rate at the time of the purchase, the value of the security and the time period. Next, the investor is provided With the proceeds from the sale based on the exchange rate at the time of the sale if the exchange rate at the time of the sale is greater than the exchange rate at the time of the purchase. Finally, the investor is provided With the proceeds from the sale based on the exchange rate at the time of the purchase if the exchange rate at the time of the purchase is greater than or equal to the exchange rate at the time of the sale. In an exemplary embodiment, if the value of the security appreciates after the purchase, the method includes the step of calculating the cost for hedging against the currency risk based on the appreciated value of the security. In an exemplary embodiment, if the investor desires to extend the time period for hedging against the currency risk, the method includes the step of calculating the cost for hedging against the currency risk based on the extended time period. Accordingly, a method and system is provided by Which investors that trade in?nancial instruments in foreign cur rencies can easily purchase a hedge against the foreign exchange risk associated With a transaction involving a particular security. The invention accordingly comprises the features of construction, combination of elements and arrangement of parts that Will be exempli?ed in the following detailed disclosure, and the scope of the invention Will be indicated in the claims. Other features and advantages of the invention Will be apparent from the description, the drawings and the claims. DESCRIPTION OF THE DRAWINGS For a fuller understanding of the invention, reference is made to the following description taken in conjunction With the accompanying drawings, in Which: FIG. 1 is a block diagram of the system of the present invention for enabling an investor to purchase a security and hedge against a currency risk associated With such a pur chase; FIG. 2 is a How chart of the method of the present invention for receiving securities transaction and hedge requests from the investor; and FIG. 3 is a How chart of the method of the present invention for calculating the cost for hedging against foreign exchange currency risk associated With an executed securi ties transaction. DETAILED DESCRIPTION OF THE PREFERRED EMBODIMENTS Referring now to FIG. 1, there is shown a block diagram of a system 1 for enabling an investor to purchase a security and hedge against a currency risk associated With such a purchase. In communication With system 1 is a securities exchange 5 through Which an investor s transaction in a particular security is executed, such as the NeW York Stock Exchange, the American Stock Exchange, NASDAQ and the over-the- counter markets. Also in communication With system 1 is a foreign exchange data source 7 for providing system 1 With real-time foreign exchange data. A trading station 3, operated by, for example, an investor or the investor s agent, communicates With system 1 for the pur pose of executing transactions in securities and purchasing a hedge for such transactions through system 1. Trading station 3 may be, by Way of non-limiting example a personal computer executing a software program designed to interact With system 1 and trading station 3 may communicate With system 1 using any known method including, but not limited to, the Internet or dedicated communications lines. System 1 includes a user interface module 9 that com municates With trading station 3 for managing the interac tions between trading station 3 and system 1 including receiving requests from the investor to transact in a particu lar security, reporting to the investor con?rmations associ ated With such transaction and coordinating the speci?cation and purchase of a currency risk hedge associated With such transaction. System 1 also includes a trading engine 11 that manages the transactions in securities requested by the investor. Trading engine 11 sends to securities exchange 5 transaction requests received by user interface module 9 from investor and reports to investor, via user interface module 9, trade con?rmations received from securities exchange 5. The construction of trading engine 11 and the interface between trading engine 11 and securities exchange 5 is Well known Within the skill of the art. Also included in system 1 is a hedge pricing engine 13. Hedge pricing engine 13 receives from the investor, via user interface module 9, a request for hedging a particular securities transaction, for a speci?ed time period, against a currency risk associated With the?uctuation of the exchange rate between the investor s home currency and the foreign currency in Which the securities transaction took place. Upon receipt of the request for a hedge, hedge pricing engine 13 receives from trading engine 11 the details of the particular transaction for Which a hedge is sought, including the value of the transaction and Whether the transaction Was a purchase or a sale. Hedge pricing engine 13 also receives from foreign exchange data source 7 real-time foreign exchange data including the exchange rate between the foreign currency and the home currency that existed at the time the securities transaction Was executed. Based on the exchange rate in effect at the time of the securities transaction, the value of the securities transaction and the time period selected by the investor, hedge pricing engine 13 calculates a cost for insuring the securities transaction against foreign exchange risks. Once the cost for foreign exchange risk hedge is calculated, the cost for the hedge is presented to the investor, via user interface module 9, at Which point the investor may select to purchase the hedge. In an exemplary embodiment, the hedging of the exchange rate risk associated With the securities transaction may be executed by using a non-tradable FX put option American style. Such an American style option can be exercised at any time before its maturity date. The FX option is preferably an OTC option, i.e., the option is tailored for a particular securities transaction and according to the speci?c needs of the investor in regard to eg a hedging time period and a value of the securities transaction to be hedged. The OTC FX option is not tradable but linked to a particular position created by the securities transaction for the Whole 5 hedging time period. Due to the linking, the OTC FX option is automatically settled When the hedged position is settled during the hedging time period. Linking has the advantage that the investor does not need to understand the detailed mechanism and premium composition of the OTC FX option in order to hedge the exchange rate risk associated With the securities transaction. In another exemplary embodiment, the hedging transac tion may be executed using tradable currency certi?cates of the bear type having standardized strike levels and standard ized maturity dates but being broken down into eg one currency unit like one dollar. If an investor intends to hedge eg the exchange rate risk associated With a securities transaction having a transaction value of dollars, the hedging transaction thus has a volume of currency certi?cates, each currency certi?cate allows the sale of one dollar at the maturity date With a speci?c exchange rate, i.e., the strike level. As mentioned above, currency certi?cates have standardized strike levels. The currency certi?cate for purchase depends on the current exchange rate. Generally, currency certi?cates having a strike level close to the current exchange rate are automatically chosen by the system. The cost of a currency certi?cate having a particular maturity date and a particular strike level depends on the current exchange rate. Since currency certi?cates are generally tradable, linking between the position of the securities transaction and the position of the hedging transaction of currency certi?cates is not required. In other Words, the currency certi?cates may be sold by the investor indepen dently from the exchange traded item of the primary trans action. Determining the price for hedging the exchange rate risk associated With a speci?c securities transaction depends on the type of hedging transaction used. If the hedging trans action involves OTC FX options, the cost of hedging a securities transaction, i.e., the price of the OTC FX option, depends on the hedging time period, the value of the securities transaction to be hedged and the ex change rate When the securities transaction is executed. Upon execution of a securities transaction, pricing engine 13 calculates the hedging price based on these parameters. On the
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