Reading 18 Currency Management: An Introduction

Question 1

Forward Contract

Answer 1

Agreements to exchange one currency for another on a future date at an exchange rate agreed on today

Question 2

FX swap transaction

Answer 2

• Offsetting and simultaneous spot and forward transactions
• Base currency is being bought spot and sold forward (or sold spot and bought forward)

Question 3

Currency Options

Answer 3

• “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

Question 4

Domestic-currency return

Answer 4

R_DC = (1 + R_FC)(1 + R_FX) – 1

Question 5

Volatility Decomposition

Answer 5

σ²(R_DC) ≈ σ²(R_FC) + σ²(R_FX) + 2σ(R_FC)σ(R_FX)ρ(R_FC,R_FX)

where R_i is the domestic-currency return of the i-th foreign-currency asset.

Question 6

Currency Management: Strategic Decisions

Answer 6

• 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.

Question 7

The Investment Policy Statement

Answer 7

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.).

Question 8

The Portfolio Optimization Problem

Answer 8

Many portfolio managers handle asset allocation with currency risk as a two-step process:

1. portfolio optimization over fully hedged returns; and
2. 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).

Question 9

Choice of Currency Exposures: Diversification Considerations

Answer 9

• 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

Question 10

Passive Hedging

Answer 10

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.

Question 11

Discretionary Hedging

Answer 11

• 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).

Question 12

Choice of Currency Exposures: Cost Considerations

Answer 12

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

Question 13

Active Currency Management

Answer 13

Goal is to create return (alpha), not reduce risk

Question 14

Currency Overlay

Answer 14

• PM oursources management of currency exposures
• Sometimes externally hired consultants manage currency
• Similar to adding an alternative asset class
• Searching for alpha

Question 15

Formulating a Client-Appropriate Currency Management Program

Answer 15

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.

Question 16

Currency Management: Tactical Decisions

Answer 16

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.

Question 17

Base currency’s real exchange rate should appreciate if there is an upward movement in:

Answer 17

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.

Question 18

Active Currency Management Based on Technical Analysis

Answer 18

• 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

Question 19

Active Currency Management Based on the Carry Trade

Answer 19

• 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

Question 20

Active Currency Management Based on Volatility Trading

Answer 20

• 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.

Question 21

Forward Contracts

Answer 21

Investors prefer to use forward contracts:

1. Standardized in terms of settlement dates and contract sizes
2. Futures contracts may not always be available in the currency pair that the portfolio manager wants to hedge.
3. 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.

Question 22

Hedge Ratios with Forward Contracts

Answer 22

• 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

Question 23

Roll Yield

Answer 23

• 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

Question 24

Currency Options

Answer 24

• Protective put = long position in underlying + put option
• Value of options determined by intrinsic value and time value of options

Question 25

Strategies to Reduce Hedging Costs and Modify a Portfolio’s Risk Profile

Answer 25

• 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

Question 26

Over-/Under-Hedging Using Forward Contracts

Answer 26

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.

Question 27

Protective Put Using OTM Options

Answer 27

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.

Question 28

Risk Reversal (or Collar)

Answer 28

• Buy OTM put and write OTM call option

Question 29

Put Spread

Answer 29

• Reduce upfront cost of buying protective put
• Buying put option, writing call option

Question 30

Seagull Spread

Answer 30

• Put spread + selling a call
• AKA (buy $35 put, sell $25 put, sell $35 call)

Question 31

Exotic Options

Answer 31

• 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

Question 32

Cross-Hedges and Macro Hedges

Answer 32

• 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

Question 33

Minimum-Variance Hedge Ratio

Answer 33

covariance(y,x)/σ²(x)=correlation(y,x)×[σ(y)/σ(x)]

• Regression of past changes in value of portfolio
• Strong negative correlation between R_FX and R_FC naturally decreases volatility of R_DC, hedge ratio of less than 1.0 would reduce volatility of R_DC

Question 34

Basis Risk

Answer 34

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.

Question 35

Currency Management Tools

Answer 35

• 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.

Question 36

Special Considerations in Managing Emerging Market Currency Exposures

Answer 36

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.

Question 37

Non-Deliverable Forwards

Answer 37

Forward typically controled by local government, cash settled in one currency

Question 38

How professional FX forward contracts are quoted

Answer 38

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?

Question 39

Mark-to-market valuation

Answer 39

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