Currency hedging and Hedge funds (Week 10). Flashcards
Hedge funds also use techniques that give them greater clout than traditional managers. First, they sell short.
Second they use leverage
This means selling a security that has been borrowed, hoping to replace it at a later date at a lower price
Hedge funds
end-of-life reporting bias
funds stop reporting during last months prior to liquidation due to poor performance, this reates net bias in the return series. can be up to + 6%
forward rate bias
forward currency rates (used for hedging) are an unbiased indicator of actual currency movements.
insights from hedge ratio estimates
– High sensitivity to inputs suggests that reliable recommendations of the appropriate hedge ratio are difficult to extract from this type of statistical analysis. However, the analysis can be useful for understanding the drivers and illustrating the impact of various assumptions. It might also point towards the general direction to move with respect to the hedging decision.
Return from CCFs broken down into
- interest earned on the collateral held backing the futures position
- insurance premium (expected future spot price - current futures price; insurance against future movements in spot price)
- expectional variance in the future spot price of the commodity at the time the contract expires
- rebalancing yield
Hedge funds for the individual investor
- Extremely wealthy individuals or institutional vinestors would invest with 100m dollars.
- high fees
- Funds in funds available in market but individual investor, hard ot tell exact exposure in funds of funds
not approrporaite. Access is also an obstacle.
The reason for the positive correlation between the a$ and equity markets has been largely attributed to the claim that
the a$ is a commodities based currency that is tied to world economic growth. australia has a much higher dependence on commodity exports than other developed countries
however, this relationship seems to have weakened somewhat over the last few years.
considerations for setting a hedge ratio
implementation
Implementation issues such as the costs and management of hedging should be allowed for. Currency overlay management may be considered as an option, i.e. out-sourcing the management of hedging
australian investor, faced with a _____ forward rate bias in its favour
forward rate bias
hedged returns are a combination of
local asset return and the forward premium (or discount) (interest rate differential - interest rate differentials are generally small and known at any point in time)
hedged returns, at least in the short run, should be less volatile than unhedged returns.
PPP and the forward rate bias
history demonstrates, and current conditions highlight, that the a$ can drift substantially away from its PPP value such that it becomes signi cantly over or undervalued. over time, the a$ may revert to its fundamental value, but this reversion can take anywhere from about three to ten year
This possibility presents difficulties for the immediate implementation of a higher strategic hedge ratio
Drawbacks to Hedging
costs, peer risk and potential diversi cation benefit
hedge fund
personnel risk
Losing fund manager, lose investors, money wil go with hedge fund manager
why is hedge ratio unreliable
they are highly sensitive to input assumptions and hence unreliable.
Emerging Markets
The emerging markets strategy used by hedge funds involves equity or fixed income investing in emerging markets around the world.
Many emerging markets do not allow short selling, nor offer viable futures or derivative products with which to hedge . Hence, emerging markets strategies often employ long only strategies
hedged returns for both international
equities and fixed interest have been
higher than their unhedged counterparts
which refleect the forward currency risk premium. Foreign currency appears to provide diversifi cation benefits in a multi-asset portfolio, particularly with respect to equities. however, the negative correlations underpinning this diversi cation appear to be unstable
These statistical features of foreign currency returns mean that an optimal hedge ratio cannot be con dently calculated and hence over-reliance on a point estimate of the optimal hedge ratio is unwise
Does investment in CCF require superior selection of active managers to be successful
No
The investment return from an international asset is
a combination of the return on the asset, in local currency terms, as well as the return from holding foreign currency.
hedging needs to be considered in the context of a
multi-asset portfolio
Direct property funds have similar exposure to
BUT
BECAUSE
property market but price does not fluctate as much as listed.
Signifcant time lag for DP price to incorporate new info in property market. not traded frequently. traded among small group of investors. valuation of unit of DP is in discreet manner and much discretion from portfolio managers
why do we do not expect the negative correlation to persist
past few years, the strength of the negative correlation between equities and foreign currency appears to have weakened or have moved closer to zero.
b/c the relationship between the commodities and the a$ appears to have weakened recently. This could be due to the changing nature of the australian economy from commodities to a more service based economy, which may be affecting the composition of exports
globalisation of world markets has lead to an increase in the correlations between equity markets, which may increase further in the future. in turn, this could lead to an increase in the correlation between equity markets and foreign currency.
forward rate bias and optimal hedge ratio for australian investors
persistent forward rate bias seen in the australian dollar,
incorporating the forward rate bias into the analysis (along with historical covariances) produces a very high optimal hedge ratio, approaching 100%. This occurs because even conservative estimates of the forward rate bias can swamp the diversification benefits derived from holding foreign currency exposure.
The implication of these ndings is that the “theoretical” optimal strategic position for an australian investor is to be fully hedged
Problems with performance of hedge funds
published performane of hedge funds is overstated due to data issues that arise from voluntary reporting of hedge fund performance.
countries like the us, which have a zero or even negative Frb and a correlation that is closer to zero than australia, would be likely to have a
NZ
AU
lower h*, perhaps at around 50%.
New Zealand with a higher Frb and a similar correlation to australia would have an even more compelling case for full hedging
Hedge Fund strategies can be broadly split into 2 categories - directional and non-directional
benefit of Non-directional strategies
low correlation with the market and hence can make a good diversifier for investors with market exposure
we recommend that an investor start at 100% as a starting point
The strategic hedge ratio for that special investor should then be derived by taking into account the following:
- any lack of con dence in the persistence of the forward currency risk premium or of suitably negative correlations;
- the potential for reversion to PPP to affect expect returns materially over the investor’s time horizon;
- the timeframe of the investor;
- the intensity of the investor’s aversion to peer risk;
- the intensity of the investor’s desire to minimise, or at least reduce regret; and/or
- the inconvenience of cash ow uncertainty arising from hedging gains and losses.
use of leverage in hedge funds can add
additional risk for investor’s total portfolio.
Substantial counterparty risk. If they use substantial leverage, there is substantial bankruptcy risk
Drawbacks to Hedging
Peer Risk
high levels of hedging can lead to peer risk, the risk of being different.
backfill bias
when a hedge fund starts reporting to a database after a period of stellar performance, its historical data is backfilled. Estimated to be 2-5% pa.
The a$ forward rate bias has varied over time but has a positive average over the long term and also in the sub- period since the a$ oated. There are four reasons why we expect the a$ forward rate bias to persist
a) Risk Premium
if the forward rate bias arises because it is a risk premium rather than due to market inef ciency then it
is a structural rather than an accidental feature of the a$.
b) Insurance Premium
if the a$ is a risky currency, then it should be reasonable to expect that foreigners holding a$ assets will be willing to pay a premium to hedge this risk,
akin to an insurance premium
c) Positive GDP Differential
The interest rate differential should at least persist in the short to medium term because according to the Fisherian Golden Rule, interest rate differentials are linked to GDP differential
Hedge funds invest in traditional asset classes, (they should not be considered a separate asset class) but do so in a way that is more flexible, responsive and opportunistic.
as a result
hedge funds don’t rely on general market movements for the majority of their returns. Rather their performance very much depends on the skill of the hedge fund manager
what must be considered when implementing CCF
- the choice of collateral and the management of the collateral
Australian investors not wanting to take currency exposure of CCF can consider using Australian bank bills as collateral
considerations for setting a hedge ratio
cash flow
Whether the potential cash flow implications that can arise from hedging are relevant. (If loss is made on hedging, it must be settled in cash – although there will be an offsetting capital gain on asset.)
Hedge Fund strategies can be broadly split into 2 categories - directional and non-directional
Non-directional strategies
focus on security selection and are not reliant on the direction of markets. A common approach managers use is to go long undervalued securities and go short overvalued securities. If the securities behave as expected, the manager earns a return from both the long and short positions.
investment in CCF is restricted to
long positions only
There are three reasons why hedging is intuitively appealing.
- Forward rate bias
uirP does not appear to hold in practice. why? what’s the implication
The uirP fails because forward rates tend to over-estimate the depreciation of the spot rates of higher interest rate currencies.
The implication is that investors should have their international assets fully hedged if they expect a positive interest rate differential to persist systematically.
Considerations to setting a hedge ratio
How the investor views the trade-offs
for an A$-based investor, unhedged positions have generated lower returns (via missing out on forward rate bias), but have generated a lower risk as the typical portfolio is negatively correlated with foreign currency (positively correlated with the A$).
On the other hand, there is the possibility of mean reversion in the A$. These trade-offs depend on aspects such as investor risk aversion and investment horizon
what must be considered when implementing CCF
- choice of index
each of the indices has unique approach to construction and management –> expose investors to different risks and performance
e.g. Goldman Sachs Commodity Index, Dow Jow AIG Index, Deutsche Bank Commmodity Index
unhedged returns are a combination of
local asset returns + exchange rate movements
exchange rate movements are random and often large.
How do hedge funds locate investors
previously established relationships, third-party marketing firms and consulting firms
Most hedge funds charge
charge management fees (1-2% of assets under management ) plus a performance related fee (20% on returns above specified hurdle rate and high-water mark; not received unless fund return exceeds both of these criteria)) .
How Much to Hedge?
the more intense the pressure of peer group risk,
the less attractive divergence from peer group practice becomes and since, most investors are under-hedged from a theoretical perspective, that will tend to influence the optimal hedge ratio down
Implementing CCF
- Currency exposure
commodity indices are denominated in USD, reflecting the domicile of the majority of the underlying futures contracts.
hedge the currency risk
sources of investment returns for CCF
exceptional variance
exceptional variance = deviation of actual spot prices from future spot prices are very high and generate most of the volatility in realised CCF in short term
assuming commodity futures markets provide unbiased estimates of future spot prices, then deviations from actual spot prices from the expected spot prices will average to zero over time. EV is not a source of CCF ER over long term
When constructing a hedge fund portfolio, sound manager research is vital. This is because you are investing
urely in the return generating skills of the hedge fund manager. The rewards for good manager selection in the hedge fund industry are many times greate
Their timeframe and sensitivity to
peer group risk will be key. The shorter the timeframe of the investor,
, the smaller the quantum of forward currency premium foregone by remaining unhedged.
lower optimal hedge ratio down.
Long/Short Equity
anagers employing this strategy will hold both long and short positions with a net long exposure. The objective is not to be market neutral. At all times more than 50% of the assets will be held as long positions. Managers may use futures and options to hedge
when do hedge funds report
and do not report
when they are seeking investments
they cease to exist or are closed to new investments
Which performed best since Mar’85: hedged WE or unhedged WE?
Since Mar’85, a fully-hedged portfolio (ZP) happened to dominate the unhedged portfolio (UP), generating higher returns for similar SD.
However, this is specific to this period, and need not always be the case. Again, it is possible that the ex post optimal hedge ratio over any particular period is neither fully hedged nor fully-unhedged.
successfully implementing a hedge fund strategy is difficult because
As a result, most investors look to
multi manager hedge fund products. These multi manager hedge funds provide diversification across managers as well as strategies, access to a higher standard of research, access to top tier managers, ongoing monitoring and a higher level of liquidity
Drawbacks to Hedging
Peer Risk
how to avoid peer risk?
investors can avoid peer risk by being reasonably close to the hedge ratio adopted by the average asset allocation of their relevant peers across all types of super funds in australia, the average hedge ratio is about 35%.
successfully implementing a hedge fund strategy is difficult because
Its “newness”, relatively unregulated structure, tradition of non-disclosure, absence of reporting standards, and reliance on unconventional strategies
The hedge fund industry is subject to much less regulation than the traditional investment management industry.
The legal structures of many hedge funds are minimally regulated and investors are often confronted by a lack of transparency
Hedge Fund managers are often reluctant to give out their security holdings as they see it as proprietary information about their strategies.
impact of correlation between foreign currency and Australian and international equities
Since float of $A, correlation has been negative
correlations that are less negative reduce the diversification benefit of foreign currency and hence support a higher level of hedging
The range of returns and risk amongst hedge fund managers is
high; varies widely between managers
Hedge funds and survivorship bias
hedge funds disclosure is not compulsory. Portfolio manager will not report performance. This is not regulated. Decides to report to hedge fund database,
Cambridge association, they have much discretion of when to report and how much to report their performance
Including CCF in a diversified portfolio
low correlation with equities and bonds. reduce the std with little impact on mean returns
portfolio without CCF vs portfolios including 10% allocation to CCF using the DAJIG and GSCI indices
sources of investment returns for CCF
rebalancing yield
act of continually rebalancing assets leads to buy low and sell high. impact is higher for assets with lower correlations e.g. CCF
for active managers to consistently generate alpha
they must be able to consistently exploit market inefficiencies
Do hedge funds offer liquidity?
investors are required to invest their money for longer periods
How substantial is the benchmark-relative risk arising from currency hedging decisions? (see ‘Differences’)
The tracking error relative to the benchmark portfolio (BP) is 1.9% pa for the fully-hedged portfolio (ZP) and fully-unhedged portfolio (UP) portfolios. This level of tracking error is meaningful. (The standard deviation of returns across Australian growth super funds is roughly 2% pa
hedge fund attribution
Reporting hedge funds have generated
3% alpha, 4.6% beta (driven by general market movement, not skills of hedge fund) excess return 3.4% distributed to hedge fund managers
Total return of hedge fund is 11%.
what must be considered when implementing CCF
- choice of index
When may GSCI be used?
Investors comfortable with higher volatiity resulting from energy exposure
no restrictions on the max exposure to any commodity or sector.
largest exposure to one sector within this index is to energy (most volatile commodity contracts - tied directly to global economic activity and higher ER in long term to commesurate with its risk)
the strategic currency hedge ratio needs to be determined taking account the
circumstances and preferences of the investor, such as time frame, peer
risk and regret.
Examine the mean and standard deviation for the cs proxy series, as well as its correlation with ZP. What does it tell you about the effect of adding exposure to foreign currency to an Australian portfolio?
Risk:
The negative correlation of cs with the zero-exposure benchmark portfolio (-0.21 since Mar’85) suggests that some degree of foreign currency exposure will reduce portfolio risk.
While a hedge ratio of less than 100% reduces risk, the minimum variance hedge ratio (found by setting E[cs] = 0) depends on the inputs. The ex post minimum variance hedge ratio was 46% since Mar’85
There are three reasons why hedging is intuitively appealing.
Capturing equity and debt market risk premia
Full hedging delivers the MrP, while being unhedged delivers additional risk in the form of currency surprise.
The difference between unhedged and hedged returns is the currency surprise, de ned as the difference between the foreign currency return (Fc) and the interest rate differential (irD)
Fc & irD have tended to come together over time, which is likely to
be driven by the a$ mean reverting to PPP.
Hedge Fund strategies can be broadly split into 2 categories - directional and non-directional
directional
Directional strategies are market timing strategies. The manager takes long and short positions in different markets and uses leverage to magnify their exposures.
These strategies involve higher risk because they hinge on the managers making the correct calls about the direction of particular markets
e. The forward foreign currency rates for an investor are determined by the
differentials between that investor’s home interest rate with those of the rest of the world. This principle is known as covered interest rate parity
hedge fund attribution
alpha generated is shared between
Hedge fund managers and investors are sharing alpha. Hedge fund managers took larger part of excess return.
Drawbacks to Hedging
Hedging Costs
costs incurred in implementing a hedging program can act to reduce hedged returns
BUT low in australian investors passive hedging is estimated to cost about 0.06% per annum. australian investors typically face a forward discount on the a$, and thus they receive a bene t from hedging.
some other countries, particularly the us, the forward premium is also considered to be a hedging cost.
Hedge funds
survivorship bias
database includes only currently existing funds and removes funds that have closed or no longer report. leaving successful funds in the database creating an updward return bias.
what must be considered when implementing CCF
- replicating the index returns
approaches taken
apparoaches taken to gain a passive commodity futures exposure
- long position in individual futures contract
- long position in index futures contract
- total return swap
Commodity returns and equities
relationshipbroadl
broadly comparable volatility but have a low correlation with equities
There are three reasons why hedging is intuitively appealing.
- Free lunch
does it hold in Australia?
First assumption: There is strong evidence that it does not hold for the a$
Second assumption: depends on the correlation of
the foreign currency with not just the international assets, but also the other assets in the portfolio. For australian investors there appears to be empirical evidence of a signi cant negative correlation between foreign currency and both australian and international equities. The question is whether this correlation is suf ciently negative to produce diversi cation bene
what must be considered when implementing CCF
- choice of index
- the choice of collateral and the management of the collateral
- approach to replicating the index returns
- Actiev or passive management
- management of currency exposure
- costs associated with investing
Convertible Arbitrage
This strategy aims to profit from mispricing opportunities within convertible bonds and other hybrid securities.
These securities are a combination of various instruments and the price of the parcel as a whole may be different to the sum of the prices of the component parts. If this is the case there exists an opportunity to buy (sell) the parcel and sell (buy) the various component parts to lock in a profit.
The lower the portfolio risk
the higher the optimal, even at lower levels of Frb and correlation
what must be considered when implementing CCF
- choice of index
When may DJAIG and DBLCI be used?
Investor wanting less volatile streams of CCF returns
DJAIG: max of 33% of the index can be exposed to any one sector
DBLCI: largest exposure to any one sector in this index is energy at 55%
Hedge Fund
Part of total return can be generated by
general market movement
Some can be security selection skills of manager
the higher the portfolio risk,
the greater the sensitivity of the optimal hedge ratio to small changes in the inputs
There are three reasons why hedging is intuitively appealing.
- Free lunch
currency hedging producing a substantial risk reduction with no loss of expected returns.
The second assumption depends on the correlation of
the foreign currency with not just the international assets, but also the other assets in the portfolio.
hedged returns, at least
in the short run, should be less volatile than unhedged returns. however, this does not imply that hedging is always preferable to not hedging: we must consider
the possibility of
eriving a diversi cation bene t from holding foreign currency in a multi-asset portfolio.
This can occur when the correlation between foreign currency and portfolio returns is signi cantly negative.
There are three reasons why hedging is intuitively appealing.
- Forward rate bias
The proposition that the expected change in the spot currency rate should equal the interest rate differentialis known as uncovered interest rate parity (uirP). The implication of the uirP is that forward currency rates are unbiased predictors of actual currency movements, which is referred to as speculative ef ciency
uirP does not appear to hold in practice.
Implementing CCF Portfolio
- choice of theseactive management
these products attempt to add value by taking positions different from the benchmark (passive management = replicating the index)
currency surprise obviously creates risks,
investment risk, peer risk and timing risk.
investment risk is the risk/return characteristics of hedged versus unhedged returns, which is the focus of this paper.
The amplitude of the uctuations in currency surprise highlights the peer risk involved with being at the extremes of either fully hedged or fully unhedged.
fund members face timing risk when investing in unhedged products. even if in
the long run PPP holds and thus there is little difference between hedged and unhedged returns, investors still face the risk of entering and exiting an unhedged fund
at an inopportune time; for example if the a$ happens
to appreciate over the term of their investment.
Considerations to setting a hedge ratio
Why does Return need to be considered
Return that is expected from currency exposure. Aspects to consider might include:
- Forward rate bias – traditionally has generated higher returns to hedging over long run
- Mean reversion potential over long term – A$ is currently above PPP
- Tendency towards momentum in short run (known to occur in currency markets as well)
- Any views held by the investor about the currency outlook
empirical evidence is supportive of hedging
but overall
both hedged equities and fixed interest have outperformed their unhedged counterparts
Hedge funds
back-fill bias
when a fund is added to a database, its return history is also typically included, or backfilled.
Funds with successful operating performance are more likely to be added to a database, the return is biased upward. A fund that has posted poor returns does note report, and its unsucessful history is not added to the database
Considerations to setting a hedge ratio
Why does risk need to be considered
Type of risk that matters under the fund’s objectives, for example:
- Portfolio volatility – focus on correlation with ZP (negative for Australian investors, hence points to diversification benefits), although relative standard deviation also has an influence
- Peer risk – focus on hedging position of peer group, and TE arising from deviations
- Regret – 50% hedged is the minimum risk position
Drawbacks of currency hedging
The other reason unhedged currency exposure may provide diversi cation bene ts to a multi-asset portfolio
is
the sensitivity of the a$ to major economic shocks
such as the global stock market crash of 1987 and the russian debt crisis.
appears that foreign currency measured against the
a$ can provide an australian investor with portfolio diversi cation when it is needed most, for example during times of crisis
optimal hedge ratio
what can have a major impact
small changes to the input values (expected return, risk or correlation)
The forward foreign currency rates for an investor are determined by the differentials between that investor’s home interest rate with those of the rest of the world. This principle is known as covered interest rate parity
for investors in australia, New Zealand and the uK,
for investors in australia, New Zealand and the uK, where interest rates have been higher relative to other developed countries; those currencies have typically sold
at a forward discount. hence, australian investors have been paid to hedge foreign currency, as they receive a positive interest rate differential.
