Reading 17: Currency Management: An Introduction

Question 1

Emerging Markets

Answer 1

The relatively high interest rates of emerging market economies leads to an inverted pricing curve with forward prices of the emerging market currencies below their spot prices. This raises hedging cost for sellers of the currency, not buyers; sellers receive negative roll yield while buyers receive positive roll yield.

Question 2

Calls & Puts

Answer 2

Note that selling a put on the base currency is equivalent to selling a call on the price currency.

Question 3

Contract Rebalancing

Answer 3

Taking a longer dated contract instead of multiple short dated ones and rolling them over, indicates lower risk aversion. But this could result in over or under hedged positions.

Question 4

Currency Overlay

Answer 4

Outsourcing the the active currency manager to a sub-advisor that specialises in currency exposure management.

Question 5

Active Currency Management

Answer 5

Bond portfolios usually have closer to a 100% hedge ratio when compared with equities. Higher emerging market exposure would support active management given they have higher yields (carry trade).

Question 6

FX Swap

Answer 6

Not a currency swap put refers to rolling over a maturing forward contract using a spot transaction to offset maturing contract then enters into the new contract. Done two days before maturity.

Question 7

Delta

Answer 7

At the money call delta is 0.5 and put is -0.5. As they move in the money the delta moves to one (absolute) and as they move out the money the delta moves to 0.

Question 8

Domestic Currency Return

Answer 8

This is made of the foreign currency asset return and the appreciation or depreciation of the foreign currency relative to the domestic currency. When finding currency movements always have the foreign currency is the base.

Question 9

Standard Deviation of DC Return

Answer 9

Use the basic two asset variance equation after finding the single asset variance. Higher correlation between foreign currency asset return and foreign currency return will increase the volatility of returns in DC but will not effect the return itself.

Question 10

Hedging Currency

Answer 10

Arguments for not hedging currency include avoiding the costs and time taken, in long run it is a zero sum game and currencies revert to fair value. Arguments to use hedging is that in short run inefficient pricing can be exploited, international trade and central bank policies drive prices away from fair value.

Question 11

Hedging Strategies

Answer 11

Passive hedging: rules based and matches exposure to benchmark to eliminate currency risk relative to benchmark, regular rebalancing is required. Discretionary hedging: allows modest deviations from passive hedging by specific percentage. Active: greater deviations, with expectation to generate positive incremental return, not reduce risk. Currency overlay: outsourcing currency management, extreme will treat currency as asset class.

Question 12

Strategic Diversification Issues

Answer 12

In long run currencies are less volatile reducing need to hedge. Positive correlation between R(FC) and R(FX) increase need for hedge, some believe this correlation is strong with bond portfolio, so more hedging is needed. Correlations vary by time period so hedge ratio may need adjusting.

Question 13

Hedging Costs

Answer 13

Bid/asked transaction costs can add up. Purchasing options involves up front premium cost that is lost if they expire OTM. Forwards require FX swap (roll over) increasing cash flow requirements and realising gains/losses. Overhead costs (office and infrastructure). 100% hedge has opportunity cost of upside, can be split 50/50.

Question 14

Appropriate Hedging

Answer 14

Clients who have the following features should adopt fully hedged or benchmark neutral strategies: short time horizon, high risk aversion, not concerned about opportunity costs of missing currency returns, high short term income and liquidity needs, significant foreign bond exposure, low hedging costs, doubts of discretionary management.

Question 15

Active Currency Strategies

Answer 15

Economic fundamentals: in long term currency value will converge to fair value, may assume purchasing power parity will determine long run rates. Increase in value of currency is associated to lower inflation relative to other countries, higher real or nominal interest rates, decreasing risk premiums. Technical analysis: uses past prices to predict future movements (volume data not used as much) assuming they reflect fundamental info so factors are not considered expect past price trends; uses support and resistance levels and moving averages.

Question 16

Carry Trade

Answer 16

Covered interest rate parity indicates currency with higher interest rate will trade at forward discount and with lower interest rate will trade at forward premium. Carry trade is based on violation of UCIRP which states the forward rate explained by CIRP is an unbiased estimate of the spot exchange rate. Be careful in reality assuming that the forward rate is a prediction of what will happen (multitude of factors). Only good in stable market conditions, unwind if unstable.

Question 17

Volatility Trading

Answer 17

Delta hedging entails creation of a delta neutral position, with zero delta so it will not change in value with changes in underlying price, but will change in value with change in implied volatility. Long straddle and short straddle are used, a strangle can be used to provide similar but more moderate payoffs compared to straddle, as OTM calls and puts are purchased so larger movement is needed to profit. The OTM options will be cheaper.

Question 18

Forwards

Answer 18

Are available for almost any currency pair unlike futures. Do not require a margin and trading volume dwarfs that of futures. Static hedge remains until maturity and may not cover the position is portfolio value changes. Dynamic covers positions as value moves, buy or sell more forwards (amount of difference) expiring on the original specified date. Lower risk aversion and strong manager views suggest allowing greater management discretion.

Question 19

Roll Yield

Answer 19

Movement from the spot price to the forward price (not that there may be additional gain or loss related to the actual spot price at expiration. Short foreign asset requires long forward to hedge, upward sloping forward price curve produces negative roll yield and discourages hedge. A downward sloping curve would cause positive roll yield and encourage hedge. Different for shorts. Consider both roll yield and other returns (like currency appreciation) when determining hedge.

Question 20

Put Spread

Answer 20

Buy OTM puts and sell further OTM puts (i.e. buy 35 delta put and sell 25 delta put). Reduces some downside protection but will be cheaper. Seagull spread is the same but also adds selling a call, so it limits upside but reduces initial cost.

Question 21

Exotic Options

Answer 21

Knock in option comes into existence if the underlying first reaches some pre-specified level. Knock out option ceases to exist if underlying reaches some pre-specified level. Binary or digital options pay fixed amount that does not vary with difference in strike and underlying.

Question 22

Cross Hedge

Answer 22

Hedging with an instrument not perfectly correlated with exposure being hedged. Usually not needed with forward in currency as virtually all currency pairs are available. Correlation may change creating cross hedge risk.

Question 23

Macro Hedge

Answer 23

A type of cross hedge that addresses portfolio wide risk factors rather than individual portfolio assets. One type is a derivatives contract based on fixed basket of currencies. It may not precisely match the portfolio but is more efficient that individually hedging all currency.

Question 24

Minimum-Variance Hedge Ratio

Answer 24

Regression of past changes in portfolio DC value to past changes in the value of the hedging instrument being used, the hedge ratio is the beta of that regression. Strong positive correlation of R(FC) and R(FX) increases volatility of R(DC) so a hedge ratio of greater than 1 would be needed, strong negative correlation of R(FC) and R(FX) decreases volatility of R(DC) and a ratio of less than 1 would be needed.

Question 25

Emerging Markets

Answer 25

Low trading volume increases the bid/ask spread, increased further in stressed markets. Liquidity can be lower with high transaction costs to exit trades more than to enter trades (carry trade in stressed market). Currency returns distributions are non-normal with negative skew, many straggles assume normal distribution. Higher yield currencies have large forward discounts, which produces negative roll yield for seller of such forwards. Contagion is common with more tail risk.

Question 26

Non Deliverable Forwards

Answer 26

Used when government restrict movements of their currency that settle normal derivatives contracts. Brazil, China, and Russia. NDFs require only cash settlement of the profit or loss in a developed market currency. Lower credit risk with notional amounts not required.

Question 27

Basis Risk

Answer 27

Basis is change in futures versus change in spot price. Basis risk is unpredictable in the short. To reduce basis risk, buy contracts that match the hedging period.