Reading 18 Currency Management: An Introduction Flashcards
Forward Contract
Agreements to exchange one currency for another on a future date at an exchange rate agreed on today
FX swap transaction
- Offsetting and simultaneous spot and forward transactions
- Base currency is being bought spot and sold forward (or sold spot and bought forward)
Currency Options
- “Exotic” options make them flexible risk management tools
- Daily turnover in FX options market is small relative to overall daily flow in global spot currency markets
Domestic-currency return
RDC = (1 + RFC)(1 + RFX) – 1
Volatility Decomposition
σ2(RDC) ≈ σ2(RFC) + σ2(RFX) + 2σ(RFC)σ(RFX)ρ(RFC,RFX)
where Ri is the domestic-currency return of the i-th foreign-currency asset.
Currency Management: Strategic Decisions
- In the long run currency effects cancel out to zero as exchange rates revert to historical means or their fundamental values.
VS.
- Currency movements can have a dramatic impact on short-run returns and return volatility and holds that there are pricing inefficiencies in currency markets.
The Investment Policy Statement
IPS will specify:
- target proportion of currency exposure to be passively hedged;
- latitude for active currency management around this target;
- frequency of hedge rebalancing;
- currency hedge performance benchmark to be used; and
- hedging tools permitted (types of forward and option contracts, etc.).
The Portfolio Optimization Problem
Many portfolio managers handle asset allocation with currency risk as a two-step process:
- portfolio optimization over fully hedged returns; and
- selection of active currency exposure, if any.
The portfolio manager will choose the exposures to the foreign-currency assets first, and then decide on the appropriate currency exposures afterward (i.e., decide whether to relax the full currency hedge).
Choice of Currency Exposures: Diversification Considerations
- In the long run it does not matter if the portfolio is hedged
- Liquidity needs (liquidation of foreign assets), would hedges cost too much money for the short term?
- Correlation between FX returns and fixed-income returns: both assets respond strongly to inflation/interest
- Hedge ratio to figure out
Passive Hedging
Passive hedging is a rules-based approach that removes almost all discretion from the portfolio manager, regardless of the manager’s market opinion on future movements in exchange rates or other financial prices.
Discretionary Hedging
- Similar to passive hedging in that there is a “neutral” benchmark
- PM has limited discretion on how far to allow actual portfolio risk exposures to vary from the neutral position.
- Discretion is a percentage of foreign-currency market value (the portfolio’s currency exposures are allowed to vary plus or minus x% from the benchmark).
Choice of Currency Exposures: Cost Considerations
Heding costs: trading costs and opportunity costs
Trading costs
- Bid-ask spread
- Currency options (up-front premium required)
- Administrative infrastructure for trading
Opportunity costs
- 100% heding has an opportunity cost with no possibility of favorable currency movement
Active Currency Management
Goal is to create return (alpha), not reduce risk
Currency Overlay
- PM oursources management of currency exposures
- Sometimes externally hired consultants manage currency
- Similar to adding an alternative asset class
- Searching for alpha
Formulating a Client-Appropriate Currency Management Program
Generally speaking, the strategic currency positioning of the portfolio, as encoded in the IPS, should be biased toward a more-fully hedged currency management program the more:
- short term the investment objectives of the portfolio;
- risk averse the beneficial owners of the portfolio are (and impervious to ex post regret over missed opportunities);
- immediate the income and/or liquidity needs of the portfolio;
- fixed-income assets are held in a foreign-currency portfolio;
- cheaply a hedging program can be implemented;
- volatile (i.e., risky) financial markets are; and
- skeptical the beneficial owners and/or management oversight committee are of the expected benefits of active currency management.
Currency Management: Tactical Decisions
There is no simple formula, model, or approach that will allow market participants to precisely forecast exchange rates (or any other financial prices) or to be able to be confident that any trading decision will be profitable.
Base currency’s real exchange rate should appreciate if there is an upward movement in:
The base currency’s real exchange rate should appreciate if there is an upward movement in:
- its long-run equilibrium real exchange rate;
- either its real or nominal interest rates, which should attract foreign capital;
- expected foreign inflation, which should cause the foreign currency to depreciate; and
- the foreign risk premium, which should make foreign assets less attractive compared with the base currency nation’s domestic assets.
Active Currency Management Based on Technical Analysis
- Assume market is liquid and freely traded
- Historical price data and help project future movements
- Historical patterns tend to repeat
- Does not figure out where markets should trade, figure out where they will trade
- Believe in levels of resistance and support
- DMA
Active Currency Management Based on the Carry Trade
- The carry trade is a trading strategy of borrowing in low-yield currencies and investing in high-yield currencies
- Based on a violation of uncovered interest rate parity (UCIRP)
- Exploits a violation of interest rate parity, can be reffered to as trading the forward rate bias
- Assumes the currency with the higher interest rate will depreciate but not as much as the market anticipates it will
Active Currency Management Based on Volatility Trading
- Delta: The sensitivity of the option premium to a small change in the price of the underlying of the option, typically a financial asset. This sensitivity is an indication of price risk.
- Vega: The sensitivity of the option premium to a small change in implied volatility. This sensitivity is an indication of volatility risk.
Deltas for puts can range from a minimum of –1 to a maximum of 0, with a delta of –0.5 being the point at which the put option is ATM; OTM puts have deltas between 0 and –0.5. For call options, delta ranges from 0 to +1, with 0.5 being the ATM point.
Forward Contracts
Investors prefer to use forward contracts:
- Standardized in terms of settlement dates and contract sizes
- Futures contracts may not always be available in the currency pair that the portfolio manager wants to hedge.
- Futures contracts require up-front margin (initial margin), they also have intra-period cash flow implications
Forward contracts are more liquid than futures for trading in large sizes. Reflecting this liquidity, forward contracts are the predominant hedging instrument in use globally.
Hedge Ratios with Forward Contracts
- A static hedge (i.e., unchanging hedge) will avoid transaction costs, but will also tend to accumulate unwanted currency exposures
- A dynamic hedge is rebalanced periodically, costs more but gives portfolio more currency hedge
Roll Yield
- The roll yield = results from the fact that forward contracts are priced at the spot rate adjusted for the number of forward points at that maturity
- A positive roll yield results from buying the base currency at a forward discount or selling it at a forward premium
- Contango hedging = negative roll yield
- Backwardation hedging = positive roll yield
Currency Options
- Protective put = long position in underlying + put option
- Value of options determined by intrinsic value and time value of options
Strategies to Reduce Hedging Costs and Modify a Portfolio’s Risk Profile
- Forward Contracts→Over-/under-hedging→Profit from market view
- Option Contracts
- OTM options→Cheaper than ATM
- Risk reversals→Write options to earn premiums
- Put/call spreads→Write options to earn premiums
- Seagull spreads→Write options to earn premiums
- Exotic Options
- Knock-in/out features→Reduced downside/upside exposure
- Digital options→Extreme payoff strategies
Over-/Under-Hedging Using Forward Contracts
If the neutral benchmark hedge ratio is 100% for the base currency being hedged, and the portfolio manager has a market opinion that the base currency is likely to depreciate, then over-hedging through a short position in P/B forward contracts might be implemented—that is, the manager might use a hedge ratio higher than 100%. Similarly, if the manager’s market opinion is that the base currency is likely to appreciate, the currency exposure might be under-hedged.
Protective Put Using OTM Options
One way to reduce the cost of using options is to accept some downside risk by using an OTM option, such as a 25- or 10-delta option.
Risk Reversal (or Collar)
- Buy OTM put and write OTM call option
Put Spread
- Reduce upfront cost of buying protective put
- Buying put option, writing call option
Seagull Spread
- Put spread + selling a call
- AKA (buy $35 put, sell $25 put, sell $35 call)
Exotic Options
- Anything that is not “vanilla” (European put and calls)
- Designed to customize risk exposure, provide lowest price
- Knock-in/knock-out: option that becomes available after a certain event
Cross-Hedges and Macro Hedges
- Cross-hedge (proxy-hedge): a position in one asset is used to hedge the risk from a different asset
- Macro hedge is an example of a proxy-hedge
Minimum-Variance Hedge Ratio
covariance(y,x)/σ2(x)=correlation(y,x)×[σ(y)/σ(x)]
- Regression of past changes in value of portfolio
- Strong negative correlation between RFX and RFC naturally decreases volatility of RDC, hedge ratio of less than 1.0 would reduce volatility of RDC
Basis Risk
Risk that the value of a futures contract (or an over-the-counter (OTC) hedge) will not move in line with that of the underlying exposure.
Alternatively, it is the risk that the cash futures spread will widen or narrow between the times at which a hedge position is implemented and liquidated.
Currency Management Tools
- Writing options to gain upfront premiums.
- Varying the strike prices of the options written or bought.
- Varying the notional amounts of the derivative contracts.
- Using various “exotic” features, such as knock-ins or knock-outs.
Special Considerations in Managing Emerging Market Currency Exposures
Emerging Market hedging consideration:
(1) higher trading costs than the major currencies under “normal” market conditions, and
(2) the increased likelihood of extreme market events and severe illiqluidity under stressed market conditions.
Non-Deliverable Forwards
Forward typically controled by local government, cash settled in one currency
How professional FX forward contracts are quoted
Forward exchange rates are quoted in terms of “points”, aka the difference between the forward FX rate and the spot FX rate
How much of a premium or discount is the spot rate trading at?
Mark-to-market valuation
Reflects the profit (or loss) that would be realized by closing out a forward contract at the current price, allows parties to judge the effectiveness of the hedge and measure profitability
