6.3 (Reading 17): Currency Management: An Introduction

Direct Hedges

- Long exposure is hedged by selling it forward - Short exposure is hedged by buying it forward - Hedged item and the hedging vehicle are perfectly correlated -> low basis risk

Offsetting Transactions and Mark to Market

- mark to market desirable or required for regulatory purposes Mark to market is = pv of any gain or loss realized if contract closed early (offset) --> remember that increase in quote means base currency appreciated and price depreciated

Currency Management Facts

1. Make foreign currency base currency 2. Determine which currency exposure needs to be increased or decreased. Talk in terms of base currency. 3. Buying futures, forwards, or call on currency increases exposure to the base currency; Selling/buying put reduces exposure -- > A call on base currency is a put on the price currency (vice versa) 4. Hedging is not free --> forwards have no initial cost but high opportunity cost(limit upside) --> options have high initial cost (premium) but low opportunity cost --> Reducing initial option cost requires reducing the downside protection or upside potential 5. Discretionary hedging: giving the manager discretion can lowing hedging costs and enhance returns; but also increases risk of underperformance 6. IPS/question should define strategic policy neutral hedge

Active Management - Carry Trade

3 important issues to understand about the carry trade: 1. Covered Interest Rate Parity (CIRP) holds and establishes that difference btwn S & F exchange rates equals the difference in the periodic interest rates of the two currencies - Currency with higher rate will trade at a forward discount; F < S - Currency lower higher rate will trade at a forward premium; F > S 2. Uncovered Interest Rate Parity (UCIRP): carry trade is based on violation of the UCIRP; Forward exchange rate is a biased estimate of the spot rate 3. Because the carry trade exploits a violation of interest rate parity, it can be referred to as trading the forward rate bias Carry Trade: borrowing in a lower interest rate currencies of developed economies (i.e. funding currencies) and investing the proceeds in a higher interest rate currencies of emerging economies (i.e. investing currencies) -> usually profitable, but has generated significant losses in periods of market crisis when investors flee high risk currency causing it to sharply depreciate Schweser Blue box pg 293 Forward rate not a good predictor of future spot rate (disagrees with UCIRP): - empirical evidences shows higher rate currency tends to appreciate, not depreciate - carry trade is based on higher rate currency appreciating or depreciating less than suggested by UCIRP

Tactical Currency Management

Active management: requires that manager have a view or prediction of what will happen TAA based on four approaches: 1. Economic fundamentals 2. Technical Analysis 3. The Carry Trade 4. Volatility Trading -> none work consistently

FX Swap

FX swap: not an actual currency swap or swap in general - Fx swap just rolls an expiring forward contract, into a new forward contract - offset first, then buy new forward contract

Price and Base Currency

Base currency is the denominator and it is priced relative to numerator; buy/sell refer to base unless otherwise stated - Sell 100 CAD/USD at spot 0.98 --> sell 100 USD and buy 98 CAD - buy 100 CAD/USD at spot 1.4 --> Buying 100 USD and selling 140 CAD - Buy 50 USD/CHF at forward rate of 1.07 --> buy 50 swiss francs, settling in 6 months FX quotes: - Base -> price: up the bid and multiply - Price -> base: down the ask and divide Forward premium/discount (F - S): if forward premium is positive, the base currency is trading at a premium in the forward market

Managing Emerging Market Currency Exposures

Challenges of transactions in EM currencies: 1. higher t-costs 2. increased probability of extreme events Examples of challenges: - Lower trading volumes lead to wider bid-ask spreads - Economic crisis can make trades even more costly - Lower liquidity and higher t-costs to exit trades than enter - Return distributions are non-normal: have negative skew and fat tails, while many trading strategies assume a normal distribution - Higher interest rates of EM currencies will lead to inverted curve (ie large forward discounts) resulting in: ---> higher hedge cost for sellers due to negative roll yield for investors ---> lower hedge cost for buyers due to positive roll yield - Contagion is a problem with correlations converging toward 1.0 in crises - Tail risk as EM governments artificially support currency value

Indirect Hedges

Cross Hedge (i.e. Proxy Hedge): hedging with an instrument that is not perfectly correlated with the exposure being hedged - Perfect hedge may be unavailable or expensive - Riskier because correlation can change -> increases residual risk of hedge -> basis risk ranges from low to high depending on what hedging instrument is used Macro Hedge: type of cross hedge that addresses portfolio-wide risk factors rather than the risk of individual portfolio assets - lower cost than hedging each currency within portfolio individually but can increase residual risk if hedge doesn't exactly match currency exposures of portfolio

Forward vs Futures

Currency forwards are generally preferred to futures for currency hedging because: - greater customization - available on any pair - avoids cost and complexity of margin cash flows - provide better liquidity

Currency Option Basics

Currency options: require two currencies; a call on one is a put on the other -> option is from base perspective Ex. Call option to buy 10M @ strike of 14.56 ZAR/GBP -> right to buy 10M GBP and sell 145.6M ZAR -> also a put option: right to sell 145.6M and buy 10M GBP

Trading Strategies to reduce costs and adjust risk return - Options

Discretionary or option-based hedging strategies are designed to reduce opportunity cost that we see in forward hedge "Plain Vanilla" Option Strategies: (Highest -> Lowest initial option cost) 1. Buy ATM put options (i.e. protective puts or portfolio insurance) - removes all downside risk and retains upside potential - ATM options are expensive - ATM put option delta = -0.5 (i.e. 50-delta put) - highest initial cost but no opportunity cost 2. Buy OTM put options - Puts are less expensive the further they are OTM but offers less downside protection - manager will have downside exposure down to strike price but retains all upside potential - OTM put < 50 delta; lower initial cost 3. Collar (i.e. short a risk reversal strategy) - Sell a higher strike price OTM call option and buy a lower strike OTM put option - provides downside protection below the put strike price and retains upside potential to the call strike price -> purchase of OTM put provides some downside protection and is cheaper than ATM put -> sale of OTM call removes some upside potential (increasing opportunity cost) but generates premium to reduce initial cost 4. Put Spread - Buy OTM puts with higher strike price and sell OTM puts with lower strike price -> provides downside protection only between two strike prices (if currency falls below lower strike of the short put, downside protection is lost) -> retains all upside potential; lower initial cost 5. Seagull Spread - Put spread combined with selling an OTM call -> provides same downside protection as put spread but limits upside potential to the call strike price; lower initial cost than put spread

Foreign Investment Risk

Domestic investor has two sources of risk: - fluctuation in exchange - fluctuation of asset price in foreign currency Var(Rdc) ≈var(Rfc)+var(Rfx)+2stdev(Rfc)stdev(Rfx)corr(Rfc,Rfx) Correlation between Rfc and Rfx - positive correlation: Rfc returns are amplified by Rfx returns, increasing the vol of return to domestic investor - negative correlation: Rfc returns are dampened by Rfx returns, decreasing the vol of return to domestic investor If Rfc is a Risk-Free Return: Rfx is the only source of risk for the domestic investor -> σ(Rdc) = σ(Rfx) x (1+Rfc)

Foreign Investment Return

Domestic investor in a foreign asset has two sources of return Domestic Currency Return (Rdc) accounts for: - Foreign-currency return: return of the foreign asset measured in foreign currency (Rfc) (i.e. local market return) - %Δ in value of the foreign currency (Rfx); i.e. local currency return Rdc = (1+Rfc) (1+Rfx) - 1 = Rfc+Rfx+(Rfc)(Rfx) Rdc ≈ Rfc + Rfx -simply adding Rfc and Rfx gives approximation - exchange rate quotes must use foreign currency as the base to calc change in value of the foreign currency (Rfx) with multiple investments in foreign calculate returns in domestic, then sum the weighted returns

Active Management - Economic Fundamentals Approach

Economic Fundamental Approach - assumes that long term currency value will converge to fair value and short term deviations can be exploited Increases in the value of a currency are associated with currencies: - more undervalued relative to their fundamental value - that have greatest rate of increase in fundamental value - with lower inflation relative to other countries - with higher real (or nominal) interest rates - of countries with decreasing country risk premium --> opposite for declining currency values

Factors influencing currency appreciation/depreciation

Expect appreciation in currencies: - Higher relative interest rates as they attract capital - Forward discount which is caused by higher interest rate and associated with appreciation! - Lower relative volatility

Factors that shift SAA decision for Currency hedging

Factors that shift the SAA decision towards a hedged strategy - A short time horizon for portfolio objectives - High risk aversion - A client who is unconcerned with the opportunity costs of missing positive currency returns - High short-term income and liquidity needs - Significant foreign currency bond exposure - Low hedging costs - Clients who doubt the benefits of discretionary management

Realized G/L on currency futures/forwards

G/L (in price currency) = V0 (F0 - Ft) V0 = Investment in base currency F0 = initial Forward fx rate using price/base Ft = ending spot exchange rate using price to base Example: Short CNY; what is G/L in USD 1. investment size must be in USD 2. Determine the G/L on the USD position in CNY. The two exchange rates need to be in CNY/USD G/L (price) = (F0 CNY/USD − Ft CNY/USD) × $Inv. USD = G/L in CNY 3. Determine the G/L in USD based on ending spot exchange rate G/L (base) = G/L in price × Ft USD/CNY = G/L in USD

Roll Yield

Hedging exposes the portfolio to roll yield Roll yield: return from the movement of the forward price over time toward the spot price of an asset -> profit or loss on future/future contract if spot price is unchanged at contract expiration -> affects cost-benefit analysis on whether to hedge Determining whether roll yield produces profit or loss depends on: 1. whether currency is trading at forward premium or discount 2. whether it's purchased or sold Roll yield = (F - S) / S = Hedged Currency Return! If F > S then forward price curve is upward-sloping. -> A short forward position earns positive roll yield as F rolls down to S If F < S then forward price curve is downward-sloping. A short forward position earns negative roll yield Issues with Forward Currency Hedging: 1. Positive (negative) roll yield will reduce (increase) hedging cost compared to the initial spot price 2. Hedging locks in the forward price as an end of period exchange rate -> opportunity cost Similarities: Roll Yield and Trading the Forward Rate Bias (i.e. Carry Trade) - both depend on initial interest rate differential btwn two currencies - both buy the higher yielding currency

Exotic Options

Introduce features not found in standard options 1. Knock-in option: plain vanilla option that only comes into existence if the underlying first reaches some prespecified level 2. A knock-out option: standard option that ceases to exist if the underlying reaches some prespecified level 3. Binary or digital options: pay a fixed amount that does not vary with the difference in price between the strike and underlying price.

Minimum Variance Hedge Ratio (MVHR)

Minimum Variance Hedge Ratio (MVHR) - Regression-based approach to determining the hedge ratio that will minimize past vol of returns to domestic investor -> regression of past Δs in value of the portfolio (Rdc) to past Δs in value of hedging instrument in order to minimize the value of the tracking error between the two variables -> hedge ratio = beta (slope coefficient) of regression Basis risk: MVHR exposed to changing correlation and likely to have the highest basis risk vs direct and cross hedges Uses of MVHR - jointly optimize over changes in value of Rfx and Rfc to minimize the volatility of Rdc Examples: Foreign country is heavily dependent on imports - Appreciation of the currency (+RFX) would make imports less expensive, which will decrease production costs, increasing profits and asset values (+RFC) --> Strong positive correlation between RFX and RFC increases the volatility of RDC --> A hedge ratio > 1.0 would reduce the volatility of RDC Foreign country is heavily dependent on exports - Appreciation of the currency (+RFX) would make its exports more expensive, which will reduce sales, profits, and asset values (-RFC) --> Strong negative correlation between RFX and RFC naturally decreases the volatility of RDC --> A hedge ratio l < 1.0 would reduce the volatility of RDC

Strategic Choices in Currency Management

Neither academic nor empirical evidence support a clear decision on the optimal approach to currency management - active approach hedges, passive does not Arguments against hedging currency: - Avoid time and cost of hedging/trading currencies - In the long run, unhedged currency effects are a Zero-sum game, because when one currency appreciates the other depreciates - In the long run, currencies revert to a theoretical fair value Argument for Active Management i.e. hedging: - Short-run currency movements can be extreme leading to misvaluations to exploit - Many fx trades are dictated by international trade or CB policy; these are not motivated by consideration of fair value and may drive currency away from fair value

Non-deliverable forwards (NDFs)

Non-deliverable forwards (NDFs): used for situations where EM governments restrict transactions in their own currency Pricing of NDFs: - pricing reflects the supply and demand conditions in the offshore market; this may be different than the onshore market of the specific emerging market country -> does not follow CIRP Main benefit -> lower credit risk than regular forward - This is because there is no required delivery of notional amounts -> only require cash settlement of G/L in developed market currency at settlement (instead of currency exchange) Note: 1. The Non-Controlled Currency is usually the USD or some other major currency 2. The Controlled Currency is the emerging market currency

Currency Management Strategies

Passive -> Active Passive hedging: - Match portfolio's exposures to benchmark exposures; rules based - Requires periodic rebalancing -Goal: Eliminates currency risk relative to benchmark Discretionary hedging: - Allowable deviations are defined by specified percentage - Primary goal: reduce currency risk while allowing the manager to pursue modest incremental currency returns relative to the benchmark Active currency management: - Wider deviations from benchmark are allowed - Goal: is adding incremental return (alpha), not risk reduction Currency overlay: - outsourcing of currency management; currency treated as an asset class - Objective: Alpha; overlay manager take positions independent of other portfolio assets to generate currency alpha - Overlay managers can also be given a pure risk reduction mandate

Trading Strategies to reduce costs/adjust risk return - Forwards

Perfect hedging is expensive in terms of opportunity cost when using forwards Strategy: Over or under hedge with forwards contracts - Currency appreciating --> reduce hedge ratio; hedging less than the full exposure to base currency risk - Currency depreciating --> increase hedge ratio; hedging more than the full exposure to base currency risk If strategy is successful: - it creates positive convexity -> gains increased and losses reduced - relatively low cost strategy

IPS Specifications

Policy on whether to hedge or not to hedge currency risk should be recorded in IPS - Relevant sections in reaching this strategic decision include investor objectives, time horizon, liquidity needs, portfolio benchmark IPS should also specify: - target percentage of currency exposure to be hedged - allowable discretion for the manager to vary around target - frequency of rebalancing - benchmarks to use for evaluating the results of currency decisions - allowable or prohibited hedging tools

Currency Management - Active Trading Rules

Relative currency appreciation - reduce hedge or increase long position Relative currency depreciation - increase hedge or decrease long position Volatility increasing - long straddle or strangle Volatility decreasing - short straddle or strangle Stable market - carry trade Market crisis and spike in volatility - discontinue the carry trade

Static vs. Dynamic Hedging

Static hedges are held to expiration Dynamic hedges are adjusted; periodically rebalanced Choice of hedging approach should consider: - Shorter-term contracts or dynamic hedges tend to improve the hedge results but increase t-costs - Rolling shorter-term contracts creates interim cash flows - Higher risk aversion suggests more frequent rebalancing - Lower risk aversion and strong manager views suggests allowing manager greater discretion around strategic hedging policy Forwards to hedge: - Static Hedge: sell forwards in the market to lock in a price, then at expiration, adjust the size of the contract to rollover and match new value - Dynamic: during contract period, adjust the amount of forward contracts to make sure fully hedged; all cash flows deferred until end of period

Strategic Diversification and Cost Issues

Strategic Diversification issues: - In the longer run, currency volatility has been lower in the shorter run -> reduces need to hedge long-term portfolios - Positive correlation of Rfc and Rfx increase volatility of Rdc and increase need for currency hedging - Correlation tends to vary by time period, providing diversification in some periods and not in others so a varying hedge ratio is appropriate - Empirical evidence indicates higher, positive correlation in bond than in equity portfolios - Hedge ratio (ie percentage of currency exposure to hedge) varies by manager preference Strategic Cost Issues: cost-benefit analysis required as hedging is not free - Bid/ask cost on a single transaction is small, but repeated tcosts add up. - Option purchases to hedge require an upfront premium cost - Forward currency contracts are often shorter term than the hedging period, requiring contracts to be rolled over as they mature (FX swap); hedge decreases return vol but the rollover can create CF volatility with realized G/L on maturing contracts --> Financing cash outflows when interest rates are high can be costly as the interest that would have been earned on the funds is lost - Overhead costs needed for hedging can be high - 100% hedging has opportunity cost of no possibility of favorable currency movement

Active Management - Technical Analysis

Technical analysis of currency is based on 3 principles: 1. Past price data can predict future price movement 2. Fallible human beings react to similar events in similar ways and therefore past price patterns tend to repeat 3. Unnecessary to know what the currency should be worth (i.e. fundamental value); only necessary to know where it will trade FX technical analysis focuses primarily on price trends; not volume Typical patterns technicians seek to exploit: - An overbought (or oversold) market has gone up (down) too far and thus will mean revert - A support level exists where there are substantial bids from customers to buy. A price that falls to that level is then likely to reverse and bounce higher - A resistance level exists where there are substantial offers from customers to sell. A price that rises to that level is likely to reverse and bounce lower as sales are executed - Shorter-term moving average moving above (below) a longer-term moving average signals prices will continue to buy (sell) further

Active Management - Volatility Trading

Volatility Trading: - uses currency options - Profit from correctly predicting changes in volatility (vega) by creating delta neutral positions through delta hedging Delta Neutral Position: Will not gain or lose value with small changes in the price of the underlying, but will gain or lose value when implied volatility changes - Positions can be "tilted" to net positive or negative based on the manager's view: --> expects currency to appreciate, shift to net positive delta --> expects currency to depreciate, shift to net negative delta Strategies: - If volatility expected to increase, a long straddle (at-the-money call and put with same delta) should be purchased - If volatility expected to decrease then use a short straddle - If volatility is expected to be low then use the carry trade - Long strangles (out-of-the-money calls and puts with same delta) can be used; options cost less but also return less as OTM will require larger movement in currency value

Bid/Asked quotes

smaller number written first, larger second, difference between the two is the spread Bid- dealer buying the currency; Asked is dealer selling currency; both numbers refer to one of the currencies vs base currency Example: quote of 0.9790/0.9810 CAD/USD Four interpretations: Deliver more CAD can be phrased as: -> Buy 1.0000 USD and deliver (sell) 0.9810 CAD -> Sell 0.9810 CAD and receive (buy) 1.0000 USD Receive less CAD can be phrased as: -> Sell 1.0000 USD and receive (buy) 0.9790 CAD -> Buy 0.9790 CAD and deliver (sell) 1.0000 USD

Spot vs Forward

spot = immediate forward = in the future - forward price given directly or spot + points --need to move the points quotes decimal left the number of decimal places spot price is quoted

FX Swaps to Adjust hedging Ratios

used to make sure that cash flows occur on day of forward expiration; two days prior to initial contract expiration - take the opposite position to cover, and sell new amount forward to rollover - Difference between initial forward and spot produces a gain or loss