R21 Currency Management

Question 1

R21

IPS currency management policy

Answer 1

The IPS’ currency management policy must address:
• How much currency exposure should be hedged passively
• Degree of latitude for diversion from the above
• How frequently hedges should be rebalanced
• Currency hedge performance benchmark
• Permitted hedging tools (forwards, swaps, options, etc.)

Question 2

R21

Diversification Considerations

Answer 2

Diversification Considerations:

• Time horizon: FX is mean-reverting in long run, so less hedging is needed
• Correlation between R_FC and R_FX : tends to be stronger for fixed income than for equity, so fixed income portfolios are more likely to be hedged

Question 3

R21

Costs of Hedging

Answer 3

• Bid Offer Spread
• Options Premium
• Roll-Over cost of forwards
• Adminstrative infrastructure for trading FX derivatives
• Opportunity Costs

Question 4

R21

When is a highly hedge policy appropriate

Answer 4

A more currency risk -averse and highly hedged policy will be appropriate, if:

• • There are short -term objectives
• • Client is very risk averse
• • There are immediate income/liquidity needs to be met out of the portfolio
• • More fixed income securities are held in a foreign fixed income currency portfolio
• • A low-cost hedging program is possible
• • Financial markets
• • Client does not believe active currency management will improve portfolio returns or reduce risk

Question 5

R21

Forwards and Foreign Currency Receipts

Answer 5

When a company is recieving cashflows in a foreign currency they are long the currency. Company sells its products in many countries >>> therefore short currency forward contract

Question 6

R21

Forwards and Foreign Currency Payment

Answer 6

• When a company has to purchase the foreign currency they are short the currency. Company has to buy resources from foreign company e.g. steel >>> therefore long currency forward contract

Question 7

R21

Hedging Returns - what is earnt

Answer 7

• Hedging the foreign market return only, expect to earn only the risk foreign free rate.
• Hedge foreign market return and exchange rate earn only the domestic risk free rate

Question 8

R21

Direct vs Indirect Quote

Answer 8

Direct Quote:

DC/FC

Note DC (Price Currency)/ FC (Base currency)

Indirect Quote:

FC/DC

• Focus on the denominator

Question 9

R21

DAD acromyn

Answer 9

DAD = Down the Ask and Divide

Question 10

R21

R_dc, R_fc, R_fx definitions

Answer 10

R_dc = return on the portfolio in domestic currency

R_{<strong>fc</strong>} = return on the foreign asset in foreign (local) currency terms

R_fx = return on foreign currency (% change in value of foreign currency

If you hold an asset in a foriegn currency you want the foreign currency to appreciate. If I have a liability I want the foreign currency to depreciate.

domestic currency = home currency

Foreign currency = local currency

Question 11

R21

Currency Hedging Methods (4)

Answer 11

• Passive - eliminate currency risk relevent to the benchmark. Match currency exposure to benchmark. difficult because of rebalancing considerations.
• Discretionary - some deviation from benchmark by a small percentage. To reduce currency risk and enjoy modest incremental currency returns
• Active - large deviations from benchmark. Goal to make incremental returns from managing currency exposure. Within risk limits.
• Currency Overlay manager - external 3rd party manages currency by active manager. Can take exposures seperately from assets held in portfolio. Generatign currency alpha.

Question 12

R21

Currency hedging conclusions

Answer 12

• Currency volatility in long run has generally been lower in long run
• When + correlation between foreign asset and foreign currency it will increase volatity in domestic returns in the portfolio and therefore increase hedging need.
• When - correlation between foreign asset and foreign currency it will decrease volatity in domestic returns in the portfolio and therefore decrease hedging need.
• Correlations vary by time periods. Therefore diversification varies.
• Higher positive correlation between foreign asset and foreign return in fixed income portfolios then equity portfolios. Therefore increased fixed income in portfolio then increased need for hedging.
• Amount of hedging down to managers preference

Question 13

R21

Hedging costs

Answer 13

• Fully hedging increase costs - reduced returns.
• If options used to hedge expire premium is lost - reduced returns
• If forward contracts need to roll often (if less than hedging period) then could result in gains or loss depending on exchange rate.
• Administrative costs
• 100% hedging has opportunity cost. A 50% strategic hedge is often preferred.

Question 14

R21

Short term strategies (tactical)

Economic Fundemental approach

Answer 14

• Economic Fundemental approach - in the long term currency values will converge to relative PPP. However relative does not hold over short term, but can indicate which currencies have over/under appreciated in the short term.
• Currencies that are expect to appreciate:

1. More undervalued compared to their intrinsic value
2. Greatest rate of increase in its intrinsic value
3. Are those with higher real interest rates or higher nominal rates. Assumes expected inflation is the same.
4. Lower inflation rate compared to other countries
5. Lower, decreasing, risk premium

Question 15

R21

Short term strategies (tactical)

Technical Analysis approach

Answer 15

• Past price date can predict future price movements
• Therefore past price patterns tend to repeat
• It doesnt matter what a currency is really worth just where it will trade
• An overbought market would be expected to do down
• An oversold market would be expected to go up
• Support and resistance levels

Question 16

R21

Short term strategies (tactical)

Carry Trade

Answer 16

• Markets must be very stable
• It is an unhedged trade
• Must be a violation of uncovered Interest Rate Parity to profit
• Borrow in the lower IR currency and invest in higher IR currency.
• If you expect the foreign currency to depreciate by less than the market expectation based on the forward discount you would enter a carry trade. However if the deprecation is far more than market expectation the losses will be great.
• High IR currency in emerging markets can drop very sharply in time of economic stress.

Question 17

R21

Short term strategies (tactical)

Carry Trade: detailed steps

Answer 17

Assume US IR = 1% and SR - 5%

1. Borrow in low IR currency e.g $1,000,000 @ 1%
2. Convert Low IR currency into High IR currency using spot rate e.g. $1,000,000 to SR @ 3.75 / $ = SR3750000
3. Invest in High IR currency asset e.g $3,750,000 x (1.05)^₁ = SR3937500
4. At end of period convert HR IR currency back to into low IR at spot rate. e.g. assuming unchanged at SR 3.75 SR3,937,500 / 3.75 = $1,050,000
5. Pay off original loan e.g. 1,000,000 x 1.01 = 1,010,000. Therefore profit of $40000 on original investment.

Question 18

R21

Short term strategies (tactical)

Volatity Trade

Answer 18

• Straddles and Strangles
• Vega
• Long Straddle - ATM buy call and ATM buy put and expecting high volatility.
• Short Straddle - ATM sell call and ATM sell put and expecting low volatility.
• Strangle - buy call and sell put but using OTM call and puts. Lower premiums.

Question 19

R21

Foward contracts for hedging

Answer 19

• Forward contracts preferred to future for currency hedgin because:

1. Can be customised
2. Can be created between any currency pairs
3. Futures require margins which increase operational complexity
4. Greater liquidity - forward market larger.

Question 20

R21

Dynamic Hedge

Answer 20

• Periodic rebalancing
• Can lead to mismatched FX swap. A forward contract for one month to cover a three month postion will need to be rolled at one month and a second forward contract for two month will need to be entered.
• A dynamic hedge will keep hedge ratio close to target hedge ratio
• Higher transaction costs than static hedge

Question 21

R21

Roll Yield

Answer 21

• Backwardation - forward price is below spot price. Roll return is positive to long side (speculators), and negative to short side (hedgers)
• Contango - forward price is above spot price. Roll return is positive to the short side (hedgers) but negative to the long side (speculator).
• Speculators expect prices to increase, but dont own asset. Will go long.
• Hedgers expect prices to decrease and own the asset. Will go short.
• Spot price assumed not to change. So forward price moves either up or down in relation to spot price. Would depend on interaction between hedgers and speculators.
• Roll yield can be seen as the profit or loss on a forward or future spot price is unchanged at expiration
• Calculate forward premium / discount:

F_dc/fc - S_dc/fc / S_dc/fc

Question 22

R21

Option based hedging strategies

Answer 22

• EUR based investor long CHF. (risk of CHF depeciation)
• Over / underhedge forward contracts based on view of investor. If CHF expected to depreciate then overhedge, if CHF expected to appreciate then underhedge.
• Buy ATM put options. Assymetic protection limits downside risk and retains upside potential. Has a higher cost.
• Buy OTM put options - cheaper, but less downside protection
• Collar - buy OTM put, sell OTM call. Reduce costs. Limits upside potential.
• Put spread - buy OTM put, sell a deeper OTM put. Reduces cost. Reduces downside protection.
• Seagull Spread - Put spread + sell call. Reduces costs further. Downside protection same as for put spread, but more limited upside.

Question 23

R21

Hedging Multiple Currencies

Answer 23

• Cross hedge / proxy hedge - a position in one assets hedges the position in another. If obvious contracts not available to short but if if two currencies are highly correlated then a proxy hedge can be created by using the other currency as a proxy. Indirect hedge.
• Macro hedge - hedge focused on whole portfolio, particularly when individual asset price movements are highly correlated. Views portfolio as a collection of risk exposures. Can use a basket of derivatives, which is less costly than hedging each instrument. Indirect hedge.
• Minimum Variance Hedge Ratio - Indirect. hedge. Uses regression analysis. To minimise tracking error between the value of the hedged asset and the hedging instrument. Not applied to a direct hedge strategy (using a foward contract). Should be re-estimated when new information becomes available.
• Basis Risk - Price movements in the exposure being hedged and the price movements in the cross hedge instrument are not prefectly correlated.

Question 24

R21

Emerging Market Currencies

Answer 24

• Lower trading volume - larger bid-ask spread
• Liquidity can be lower - higher transaction cost
• Non-normal distributions more frequent
• Higher yields, leads to large foward discounts, markets in backwardation, postive roll return to the long side, but negative to short side. Higher yield - larger inflation rate.
• Contagion - correlations between countries increase, therefore diversification benefits decrease.
• Tail-risk - negative events occur more frequently.
• Government intervention