Currency Management Flashcards
carry trade
ipc > ibc => long PC, short BC
trading the forward rate bias
ipc > ibc => F (PC/BC) > S (PC) > S (BC)
=> Long PC, short BC
roll yield
iPC > iBC
=> F (PC/BC) > S (PC/BC)
=> roll yield >0
=> Long PC, short BC
Optimization of a multi-currency portfolio of foreign assets
locate the portfolio on the efficient frontier of the trade-off between risk and expected return defined in terms of the investor’s domestic currency.
two-step process of handle asset allocation with currency risk
(1) portfolio optimization over fully hedged returns
(2) selection of active currency exposure
choice of currency exposure (to decide % hedge of the currrency exposure
(1) Diversification consideration
+ If hold long term -> no need to hedge currency exposure
+ If negative correlation -> no need to hedge
+ If asset is FI -> should hedge
(2) Cost consideration
+ Hedging cost (trading cost, oppotunity cost)
+ Hedge large movement can material affect
Currency management strategies
+) Passive hedging -> totally hedge
+) Discretionary hedging : allow for partially currency exposure
+) Active currency management: seek currency risk with profit in mandated risk limit
+) Currency overlay:
*) Internal manager: hedge- External manager: seek alpha
*) Correlation between 2 parts should be low
should hedge toward fully in:
+ short term investment
+ portfolio owner is risk averse and regret aversion
+ portfolio has liquidity & income need
+ portfolio has FI
+ hedging cheap
+ financial market volatility
+ The beneficial owners/management oversight committee are skeptical of the expected benefits of active currency management.
tactical decision of currency risk exposure invesment
+ Econ. fundamental
+ technical analysis
+ carry trade
+ volatility trading
limitation of economic fundatmental of active currency management
+ modeling factor effect fx is dificult
+ modeling equilibrium rate is difficult
limitation of technical analysis of active currency management
+ lack formal econ.model
+ subjective judment
+ less useful in trendless market
tool of currency hedge related to forward contract
+ stratic hedge (hedge 1 times initial) -> unwanted currency exposure
+ dynamic hedge:
*) if foreign increse -> should increase hedge size
*) if spot rate increase -> should increase hedge size
+ FX swaps:
+ Roll yield
*) For a long position: Roll yield= (𝑆𝑃/𝐵−𝐹𝑃/𝐵)/𝑆𝑃/𝐵
*) For a short position: Roll yield=(𝐹𝑃/𝐵−𝑆𝑃/𝐵)/𝑆𝑃/𝐵
short risk reversal
= long colar
time decay
Time decay is a measure of the rate of decline in the value of an options contract due to the passage of time
domiestic currency return of Portfolio
P𝑅𝐷𝐶=w1 x (1+ RDC1) + w2 x (1+RDC2) - 1
domestic currency return of asset class
Rdc = (1+ Rfc) x (1+Rfx)- 1
+ Rdc: Domestic currency return of asset class
+ Rfc: Foreign currency return of asset class
+ Rfx: the percentage change of the foreign currency against the domestic
currency
currency overlay program
Definition:
+) Limited: means that the PM has outsourced managing currency exposures to a firm specializing in FX management
+) Broader: hired currency overlay manager to take directional views on future currency movements
Uses:
+) the foreign-currency asset portfolio hedged + add an external currency overlay manager to the portfolio
+) currency overlay program should generate alpha that is UNCORRELATED with both the major asset classes and the other alpha sources in the portfolio
carry trade characteristics:
+ involves borrowing in low-yield currencies and investing in high-yield currencies
+ equivalent to trading the forward rate bias
+ is a leveraged position
+ lower volatility is better for a carry trade position (da hoi trong Topic test)
Non-deliverable forwards (NDFs)
Why: because some emerging country restrict movement currency move in/out of country (CNY. BRL, RUB) to settle contract -> NDFs
Benefit:
+ lower credit risk
+ tail risk (change gov policy)
+) NDF pricing will reflect the individual supply and demand conditions (and risk premia) in the offshore market
risk reversal strategy
buy an OTM put option and write an OTM call option
Volatility overlay
actively trading the portfolio’s exposures to movement in currencies’ implied volatility
Discretionary hedging appropriate for ?
- Description:
hedge for appropriate benchmark, but allow active a little bit - Use:
+ A long time horizon for portfolio objectives.
+ Low risk aversion.
+ Concern with regret at missing opportunities to add value through discretionary currency management.
+ Low short-term income and liquidity needs.
+ Little foreign currency bond exposure
+ High hedging costs.
+ Clients who believe in the bene
cross hedge (proxy hedge)
refers to hedging with an instrument that is not perfectly correlated with the exposure being hedged
Eg: Hedging the risk of a diversified US Equity with S&P future contract
Macro hedge
a type of cross hedge that:
+ addresses portfolio-wide risk factors
rather than
+ the risk of individual portfolio assets
minimum-variance hedge ratio (MVHR)
is a mathematical approach to determining the hedge ratio.
+ hedge ratio = beta (slope)
50-delta put
put is ATM
35-delta put
put is OTM
25-delta put
put is OTM
delta neutral hedging strategy
strategy make delta = 0. Eg: Stradle
strategic decision of hedge currency risk least affected by
A. manager’s market views
B. correlation between asset and currency returns
C. investor’s time horizon, risk aversion, and liquidity needs
A. because market view affect Tactical decision
active currency trading strategies
(1) economics fundamentals
(2) technical analysis
(3) carry-trade
(4) volatility trading
knock in
An option with a knock-in feature is essentially a vanilla option that is created only when the spot exchange rate touches a pre-specified level
knock-out
knock-out option is a vanilla option that ceases to exist when the spot exchange rate touches some pre-specified barrier level.
Digital options
Digital options are also called binary options, or all-or-nothing options
