2018 Study Session # 9, Reading # 19 “CURRENCY MANAGEMENT: AN INTRODUCTION” FC = Foreign currency DC = Domestic Currency HR = Hedge Ratio FI = Fixed Income CURRENCY RISK AND PORTFOLIO RETURN AND RISK 3.1 Return Decomposition Domestic asset⇒ asset that trades in the investor’s domestic currency Foreign asset ⇒ assets denominated in currencies other than the investor’s home currency FC return ⇒ return of the foreign asset measured in foreign currency terms DC return ⇒ FC return + % movement in spot exchange rate ⇒ܴ = ሺ1 + ܴி ሻሺ1 + ܴி ሻ − where ܴி⇒ % ∆ in FC against DC ⇒ The same formula is applicable to multi-currency portfolio of foreign assets ⇒ Portfolio managers would need to account for the correlations (e.g b/w exchange rate movement, FC asset returns etc.) when forming expectations about future asset price & exchange rate movement 3.2 Volatility Decomposition Above formula can be rearranged as: ܴ = ܴி + ܴி + ܴி ܴி Variance of the DC returns for the overall foreign asset portfolio: ߪ ଶ ሺ߱ଵ ܴଵ + ߱ଶ ܴଶሻ ≈ ߱ଵଶ ߪ ଶ ሺܴଵ ሻ + ߱ଶଶ ߪ ଶሺܴଶሻ + 2߱ଵ ߱ଶߪሺܴଵሻߪሺܴଶሻߩሺܴଵ, ܴଶ ሻ -ve correlation b/w variables will overall portfolio’s risk through diversification Overall portfolio’s risk also depends on the ሺ߱ ሻ used CURRENCY MANAGEMENT: STRATEGIC DECISIONS Various approaches to currency management are in place ranging from currency risk avoidance to actively seeking FX risk Well-developed set of financial products & portfolio management technique are available to manage currency risk 4.1 The Investment Policy Statement IPS mandates the degree of discretionary currency management that will be allowed in the portfolio 4.2 The Portfolio Optimization Problem Optimization of multi-currency portfolio ⇒ selecting portfolio weights that locate the portfolio on the efficient frontier of the trade-off b/w risk & expected return defined in terms of the investor’s DC Portfolio managers usually handle asset allocation with currency risk as a two step process: Portfolio optimization over fully hedged return Selection of active currency exposure Copyright © FinQuiz.com All rights reserved 2018 Study Session # 9, Reading # 19 4.3 Choice of Currency Exposures 4.3.1 Diversification Considerations Many investment practitioners believe that in the long run, currencies have “mean reversion” feature (i.e un-hedged currency exposure addition does not affect long-run expected portfolio return) Correlation b/w FC return & FC asset return tends to be for fixed income portfolios than for equity portfolios Intuitive sense ⇒ bonds & currencies react strongly to movements in interest rates 4.3.2 Cost Considerations Optimal hedging decision⇒ to balance the hedging benefits against hedging costs Two forms of hedging costs include trading costs & opportunity costs 4.4 Locating the Portfolio along the Currency Risk Spectrum 4.4.1 Passive Hedging 4.4.2 Discretionary Hedging Goal is to keep portfolio’s currency exposure close to the benchmark portfolio Rules based approach that removes almost all discretion of portfolio manager “Neutral” benchmark exists as in passive hedging however manager has some limited discretion Discretion is usually defined in terms of FC market value 4.4.3 Active Currency Management 4.4.4 Currency Overlay Extension of discretionary hedging No allowance for unlimited speculation Discretionary hedger usually protects the portfolio from currency risk while active currency manager is supposed to take currency risk for profit Currency overlay program ⇒ outsourcing currency risk management task to a firm specialized in FX management Currency managers are allowed to take directional views on future currency movements One approach may be to separate the hedging & alpha function (through overlay) mandates of the portfolio CURRENCY MANAGEMENT: TACTICAL DECISIONS Tactical currency decision⇒ involves active currency management There is no simple formula, model or approach that will allow market participants to precisely forecast exchange rates Copyright © FinQuiz.com All rights reserved 2018 Study Session # 9, Reading # 19 5.1 Active Currency Management Based on Economic Fundamentals Developing a view about future exchange rate movements based on the underlying fundamentals Assumptions ⇒ In free markets, exchange rates are determined by logical economic relationships Model indicates that base currency’s real exchange rate should appreciate, if there is an upward movement in: Long run real exchange rate Real or nominal interest rates Expected foreign inflation The foreign risk premium Challenges ⇒ to model movements in real exchange rates & changes in other variables overtime 5.2 Active Currency Management Based on Technical Analysis Based on three broad themes: First ⇒historical price data can be helpful in projecting future price movements Second ⇒ historical patterns in the price data have a tendency to repeat Third ⇒ technical analysis does not attempt to determine where market prices should trade but where they will trade Technicians try to identify when markets have become overbought or oversold to identify reversal or correction Many FX active managers use technical analysis to form a market opinion or to time positions, entry & exit points 5.3 Active Currency Management Based on the Carry Trade Carry trade ⇒ strategy of borrowing in low-yield currencies & investing in high yield currencies Forward rate bias ⇒ forward rates are biased predicator of future spot rate Forward premium (discount) overstates the amount of appreciation (depreciation) Trading the forward rate bias ⇒ buying (selling) currencies selling at a forward discount (premium) The Carry Trade: A Summary Implementing the carry trade Trading the forward rate bias Buy/Invest High-yield currency Sell/Borrow Low-yield currency Forward discount currency Forward premium currency Reference: Level III Curriculum, Volume 4, Reading 18 5.4 Active Currency Management Based on Volatility Trading Trading style is unique to option markets & is known as volatility trading Volatility trade can be implemented through straddle Straddle ⇒ combination of both at-the-money put & call Profitable in more volatile markets Strangle ⇒ buying out-of-the money put & call Cheaper to take positions Volatility overlay programs, for actively trading the portfolio’s exposures to movement in currencies’ implied volatility, are also available Copyright © FinQuiz.com All rights reserved 2018 Study Session # 9, Reading # 19 TOOLS OF CURRENCY MANAGEMENT 6.1 Forward Contracts Future or forward contracts on currencies can be used to obtain full currency hedge Institutional investors prefer forwards over futures based on the following reasons: Due to standardization, futures contracts may not correspond to the portfolio’s investment parameters Futures contracts may not be available in currency pairs required for hedging Futures contracts require upfront margin 6.1.1 Hedge Ratios with Forward Contracts Actual HR may drift away from desired HR as market conditions change Static hedge ⇒ avoid transaction cost but accumulate unwanted currency risk Dynamic hedge ⇒ rebalance the portfolio periodically to manage the currency risk Actual HR remains close to target HR Risk aversion, frequency to hedge 6.1.2 Roll Yield Forward contracts are priced at spot rate adjusted for the no of forward points at the maturity Forward points may be at premium or discount (+ve or –ve roll yield) depending upon buying /selling in the market The Carry Trade and Roll Yield Implementing the carry trade Trading the forward rate bias Buy/Invest High-yield currency Forward discount currency Sell/Borrow Low-yield currency Forward premium currency Earning a positive roll yields Reference: Level III Curriculum, Volume 4, Reading 18 6.2 Currency Options Forward contracts hold opportunity cost if future currency moves are in portfolio’s favor Options remove this cost by providing right but not obligation to buy FX at agreed upon price in future Protective put ⇒ matching a long position in the underlying with a put option Option cost is the premium paid to enter into an option (based on its intrinsic value & time value) 6.3 Strategies to Reduce Hedging Costs and Modify a Portfolio's Risk Profile Cost-reduction measures, invariably involve some combination of less downside protection &/or less upside potential for hedge Hedge ratio may drift from 100% to some directional positions in order to reduce cost Select Currency Management Strategies Forward Contracts Option Contracts Exotic Options Over-/ under-hedging OTM options Risk reversals Put/call spreads Seagull spreads Knock-in/out features Digital options Profit from market view Cheaper than ATM Write options to earn premiums Write options to earn premiums Write options to earn premiums Reduced downside/upside exposure Extreme payoff strategies Reference: Level III Curriculum, Volume 4, Reading 18 Copyright © FinQuiz.com All rights reserved 2018 Study Session # 9, Reading # 19 6.3.1 Over-/Under-Hedging Using Forward Contracts Manager can add incremental value based on market view (subject to IPS permission) If base currency is likely to depreciate (appreciate) then over (under) hedging might be implemented Variant of this approach ⇒ ( ) the hedge ratio if base currency depreciates (appreciates) Form of delta hedging 6.3.2 Protective Put Using OTM Options To reduce cost of using options, accept some downside risk by using an OTM option (e.g 25 or 10 delta option) It is rational to have a cheaper insurance policy & accept responsibility for minor events 6.3.3 Risk Reversal (or Collar) Writing options to earn income that can be used to offset the cost of buying put options Cheap downside protection compared to protective put ⇒ buy an OTM put & write an OTM call option Risk reversal ⇒ long call & short put in FX markets 6.3.4 Put Spread Put spread is used to upfront cost of buying a protective put Put spread ⇒ buying put + writing put 6.3.5 Seagull Spread Seagull spread ⇒ long protective put & write both a call & a deep OTM put 6.3.6 Exotic Options Usually used by currency overlay managers Vanilla options ⇒ European style put & calls options Exotic options ⇒ options that are not vanilla Option with knock-in (knock-out) features ⇒ vanilla Option that is created (ceases to exist) when spot rate touches some pre-specified level 6.4 Hedging Multiple Foreign Currencies Very similar to hedging single currency but must consider correlation b/w various foreign currency risk exposures Copyright © FinQuiz.com All rights reserved 2018 Study Session # 9, Reading # 19 6.4.1 Cross Hedges and Macro Hedges Cross (proxy) hedge ⇒position in one asset is used to hedge the risk exposures of a different asset Macro hedges are some types of cross hedges Reason ⇒ entire portfolio is the focal point 6.4.2 Minimum-Variance Hedge Ratio A mathematical approach to determine the optimal cross-hedging ratio Minimum variance hedge ratio typically applies only for indirect hedges based on cross hedging 6.4.3 Basis Risk Basis risk ⇒ risk to portfolio when a direct currency hedge is replaced with indirect hedge All cross hedgers & macro hedges will have to be carefully monitored & rebalanced to account for the drift in correlation CURRENCY MANAGEMENT FOR EMERGING MARKETCURRENCIES 7.1 Special Considerations in Managing Emerging Market Currency Exposures Two important considerations: Higher trading costs than the major currencies Chances of extreme market events & severe illiquidity Higher costs would especially be the case for crosses in currency pairs When trades in these less liquid currencies get crowded, liquidity becomes an issue Forward contract based hedging strategies also affect from currency crises 7.2 Non-Deliverable Forwards Non-deliverable forwards ⇒ similar to regulated forward contract but these are cash settled NDF has lower credit risk than outright forward (as principal sums in the NDF don’t move) Copyright © FinQuiz.com All rights reserved ... Extreme payoff strategies Reference: Level III Curriculum, Volume 4, Reading 18 Copyright © FinQuiz. com All rights reserved 2018 Study Session # 9, Reading # 19 6 .3. 1 Over-/Under-Hedging Using Forward... reserved 2018 Study Session # 9, Reading # 19 6.4.1 Cross Hedges and Macro Hedges Cross (proxy) hedge ⇒position in one asset is used to hedge the risk exposures of a different asset Macro hedges...2018 Study Session # 9, Reading # 19 4 .3 Choice of Currency Exposures 4 .3. 1 Diversification Considerations Many investment practitioners