Is there a smart way to hedge against FX exposure?

on Jul 1, 2015 in Currency, Home | 5,557 comments

In today‘s market environment, when equities valuation are high and starting to come under pressure, and yields are at record low, it is becoming crucial for foreign asset investors to consider hedging their currency exposure. Investments in foreign instruments, such as equity and fixed income, can generate substantial returns and provide a greater degree of portfolio diversification. However, they introduce an added significant risk, namely currency risk. Since currency exposure can have a significant impact on portfolio returns, investors should consider hedging this risk appropriately and methodically. While hedging instruments such as currency futures, forwards, swaps and options have always been available, their relative complexity has hindered widespread adoption by the lambda investor. A broad industry rule of thumb is that it would be more common to see a foreign currency equity portfolio left at least partly unhedged, while a fixed income portfolio would be expected to be largely hedged. But how do we go about effectively construct a currency hedging program? This is what this article is all about. The Impact of currencies should not be overlooked As a matter of fact, currency fluctuations contribute to interim risk and may substantially increase the magnitude and likelihood of drawdowns. It might be argued that the impact of currency tends to net out at zero over the long-term. In theory, it is believed that there is purchasing power parity (PPP) between two currencies, to which they will revert to over time. This would suggest the practice of currency hedging to be irrelevant over the long term. In practice however, there are a few flaws to this argument. Currencies can trade beyond their PPP for extended periods of time, and not all investors are looking to hold an investment over the long-term. Several models describe currency movements, incorporating variables such as relative purchasing power of currencies, real and nominal interest rate differentials, and trade and financial flows. While currencies tend to follow their PPP rates in the long term, empirical studies of exchange rates have shown that currency returns exhibit non-random trends and reversals. These studies have drastic implications for currency investment policy. Moreover, over the short-term, the impact of currency can actually be quite substantial. Even for longer-term investors, currency can attribute a significant amount of additional volatility and potential drawdowns. Therefore investors recognizes that the key problem they want to solve with hedging is the avoidance of large losses from foreign currency weakening (or domestic currency strengthening), which often happen suddenly over short horizons. The trade-off is ultimately between certainty around expected cash flows and the cost of that certainty. The question which remains, is it worth it? Investors often spend considerable time developing an investment policy, or strategic asset allocation, for multiple asset class portfolios. For portfolios that include foreign investments, the policy should include guidelines and a benchmark for the management of the currency exposure. Let’s dig a step further into the two types of currency hedging program. Passive versus active currency management As mentioned previously, currency exposure is an inescapable feature of investment in foreign markets. Generally speaking, there are two types of currency management strategy, static hedging program and dynamic hedging program. The decision to any of the two approaches can have a significant effect on a fund’s performance. Static strategies, referred as passive hedging, use currency hedging to reduce both upside and downside currency risk. Managers may choose to fully hedge currency exposure, removing any impact from currency fluctuations or partially hedge in order to achieve a result somewhere between that of a fully hedged portfolio and an unhedged portfolio. A static approach provides investors with better transparency rather than being at the discretion of the portfolio manager. From the practitioners point of view, a passive currency hedging policy should be mainly driven by the volatility of its currency exposure introduce to a portfolio, not by its expected return. Whereas, dynamic strategies referred as active strategies use both fundamental and/or technical approaches has the best opportunity of consistently adding value. Active currency management strategies seek to exploit certain characteristics of currency markets, and views about currency returns should dictate tactical decisions, not policy decisions. Currency markets exhibit what are considered the three essential characteristics for active management to succeed. • Observable inefficiencies that can be captured using fundamental and technical approaches • A stylized fact, for expecting those inefficiencies to persist. As an example, the recurrent presence of nonprofit maximizers such as central banks, corporate treasurers, and foreign investors with passive currency policies • Much lower transaction costs than either equity or fixed income trades These factors imply that active currency managers have a larger opportunity than equity and fixed income managers to beat a passive approach. To summarize, passive hedging leaves you fully exposed to one or the other, or sub-optimally exposed to both. Despite the fact that dynamic hedging is not widespread, there is still significant room for investors’ consideration. What are the routes for a dynamic currency programs? Investors are taking one of two routes in their dynamic currency programs, by developing systematic or so called rule based signals into their hedging programs. Some are applying those signals with optionality, and others replicate those trades synthetically with forward contracts. The signal output will indicate hedging out significantly more those currencies that are over-valued as opposed to the under-valued ones. The primary objective is not to add realized return but to provide...

Swiss negative rates as soon as June 19th, 2014?

on May 30, 2014 in Currency, Economy, Home | 10,358 comments

Some traders are still skeptical that Mr. Draghi will make much of a move at all, then any meaningful action by the ECB president could further hurt the EUR. But we should watch out for local repercussions. The Swiss National Bank will not want to see the EUR below its CHF 1.20 minimum exchange rate target, so if that level is challenged, the SNB could introduce its own negative rates at the June 19th meeting. Cutting its deposit rate below zero is potentially a more powerful policy for the SNB to weaken its currency than for the ECB. Credit Suisse Group as mentioned in the past that it would begin charging other banks interest on CHF deposits. UBS, the country’s biggest lender by assets, also said it would charge fees on certain deposit accounts to discourage bank clients from parking cash. However, any measures have been implemented to date. A strong lending growth also entails risks for financial stability. In the past, excessive growth in lending has often been the cause of later difficulties in the banking sector. Swiss real estate is feeling the effects of the SNB’s long policy of low interest rates with prices for owner-occupied apartments growing at an average rate of 6 percent per year since 2008, which could be a source of concerned. If a central bank imposes a scenario of negative interest rates on excess reserves to the banking system, the cost of the interest will be ultimately passed along to deposit-holders (i.e. their saving customers), whether through fees or negative interest rates. Under normal conditions, depositors may be willing to pay a small fee for the convenience and security of keeping their money in the bank rather than as cash at home. However, at some point, if negative interest rates become high enough, bank depositors may elect to take their cash out of the system. For example, a credit card holder may choose to make a large upfront payment on a credit card and then run down the balance rather than the usual practice of making purchases first and payments later. In any case, the actions by the world’s central banks, the FED, that were used to avoid The Great Depression Part 2 are now coming home to roost. By using untried and untested measures to avoid what was a banking system-created crisis in the first place, central banks have backed themselves into a policy corner from which extrication may be painful. We need look no further than the current situation in Switzerland; even though it is small by world standards, the Swiss economy is showing how the impact of unconventional monetary policy can have wide-ranging and unexpected results. In my opinion, Swiss authorities should consider introducing temporary negative interest rates to discourage foreign investors from holding CHF in the event the currency begins to appreciate again and preserve its competitiveness. My conclusion is that the likelihood of a negative interest rate being imposed by the ECB is near zero. It is not going to happen. However, a bold move from Mr. Draghi could eventually trigger local repercussion and force the SNB into action...

Currency trade strategy

on Oct 4, 2012 in Currency, Home | 2,249 comments

Markets that offer the highest returns on investment will be the ones that gen­erally attract the most capital. As interest rates rise, investment will follow, which can in turn increase the value of the currency. On the other hand, the investor also should pay attention to the health of the economy from the currency pair to ensure the market will move to in his favour. The carry trade strategy is popular among investors and takes advantage of the interest rate differentials between two currencies while also hoping to benefit from the positive trend in the pair. As an example, you borrow JPY and convert them into USD and invest in cash solutions or in fixed income product for the equivalent amount. Let’s assume that the investment pays you 2% and the Japanese interest rate is almost 0%. The investor makes a profit of 2% as long as the exchange rate remains stable. Carry trade must be conducted with caution due to potential volatility on the currency pairs. Tension in markets can have drastic effects on currency pairs and can be drained by brutal turn. For many years, the JPY has been the most favoured carry trade strategy because of its traditionally low or no interest rate governmental policy. By matching the yen with a high-yielding currency from a growing economy, you can earn interest due to the difference in yield. By choosing a nation coming out of a recession and on its way to solid long-term growth with the possibility of rising interest rates, you can expect earn a decent yield. There is a fair amount of risk to the carry trade strategy mainly related to the uncertainty of exchange rates. Using the example above, if the USD was to fall in value relative to the JPY, then the investor would run the risk of losing money. When risk aversion prevails among investors and exchange rate volatility is high, the carry trade often starts to look less attractive. On the other hand, when stability has returned to the currency market, the risk appetite of investors then tends to increase. They start looking for higher returns, even if it means taking more...

The end of USD’s reserve currency domination?

on Aug 2, 2012 in Currency, Economy, Home | 1,563 comments

How could the USD’s long time most favoured currency status be in jeopardy? There is indeed great concern around the financial trajectory of the US economy. I expect that the outlook for the US fiscal position will weigh heavily on the USD in the quarters ahead. Consequently, the USD’s role as the world’s reserve currency has been called into question. In the near term, however, a strengthening growth profile could help provide a temporary period of USD strength. In the long term, the prediction of a multi polar currency world replacing the current USD dominance is a plausible scenario. Today, more than 60% of all foreign currency reserves in the world are in USD. But there are big changes on the horizon. The BRICS continue to flex their muscles and use of their own national currencies with their respective trading partners rather than the USD.  Global growth over the next decade is likely to mirror the current sluggish recovery, with emerging countries growing faster than more advanced counterparts. Currency use remains dominated by the USD despite the growing importance of emerging markets. I think it is still quite possible that this will only be a very gradual process and very likely that the USD will still play a key role in the world economy. If the world is unwilling to continue to accumulate USD, the US will not be able to finance its trade deficit or its budget deficit. The implication is for a decline in the USD’s exchange value and a sharp rise in prices. We are reaching the end of the era of the USD centric global currency system. With global demand for USD’s falling, central banks around the world will inevitably reduce their USD reserves. That reduction further weakens the USD against other currencies and in turn drives up inflation. Due to the current bearish market sentiment the stronger position of the USD is on my opinion a short term...

Currency overlay strategy

on Jul 26, 2012 in Currency, Home | 1,517 comments

As an investor with assets denominated in various currencies, your portfolio requires protection from currency exchange rate movements. Currency overlay is an investment strategy used in managing the currency exposure and aims to separate the management of currency risk from the asset allocation and security selection decisions of the investor. At its core, currency overlay strategies involve hedging the currency exposure created by a foreign investment through the use of foreign exchange forward contracts. The combination of foreign exchange forwards with foreign assets allows the risks to be managed separately. If risk reduction is the primary objective of your currency overlay, then a passive strategy is most suitable. As the name implies, it involves putting on a forward contract that is a fixed percentage of the fund’s net asset value and then leaving that hedge percentage constant over the life of the investment. Periodic rebalancing occurs only if the fund’s net asset value is adjusted. The passive overlay provides stability if its primary objective is to reduce fund volatility from currency movements. Unlike a passive approach, the active currency manager is given discretion to vary the hedge percentage, with the aim of beating their benchmark. Active overlay strategy seeks non-correlated returns (alpha) from currency risk. An active currency overlay involves an overlay manager actively changing the hedge ratio of the currencies based on expectations regarding future movements of exchange rates. If the manager of an active portfolio expects a currency to drop in value, he will increase its hedge ratio to protect against losses. If the manager expects a currency to increase in value, he will consequently reduce its hedge ratio to profit from the currency exposure. Keep in mind, it makes little sense to hedge foreign currency exposure if the investor has a strong conviction that the foreign currencies to which he has exposure will appreciate versus his base...

USD Index strength in times of market uncertainty

on May 24, 2012 in Currency, Home | 2,190 comments

The US Dollar Index (USDX) is a measure of the value of the USD relative to a basket of foreign currencies. Currently, this index is calculated by factoring in the exchange rates of the following currencies: EUR, JPY, CAD, GBP, SEK, and CHF. The current index value of 82 relative to the base of 100 set in the 70s, would suggest that the USD experienced an 18% decreased in value over the time period against the basket. The USD is indeed facing sign of dissatisfaction as a reserve currency, amid concerns over the US government’s inability to rein in spending and the Federal Reserve’s huge expansion of its balance sheet. Especially in periods of market confidence, this process is reinforced and investors want to pursue more aggressive investment strategies. Investors will often short USD and move into riskier currencies, such as the AUD, in the hope of steady appreciation. Thus, in risk on periods, the USD usually declines in value relative to commodities related currencies such as the AUD or CAD. However, in risk off periods, the USD status as a safe haven currency gains momentum, as investors avoid exposure to risky currencies and assets. Even though there is great concern around the trajectory of the USD, the USD index has risen to a 4-month high as US data stabilizes and Euro zone concerns broaden. Besides, other safe haven currencies such as JPY and CHF, which also attract investors’ attention in risk off environment, are currently out of favor. Due to the Bank of Japan and Swiss National Bank resisting own currency appreciation, the USD may maintain a safe haven status…forever? I will therefore be long USD and short AUD, CAD and especially EUR at least for the coming 6...