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 tail-risk protection. You tend to have empirically the biggest drawdowns when you are invested in over-valued currencies.
Nonetheless, it can introduce meaningful risk: it is notoriously difficult to judge over what time horizon the adjustment of a currency to its supposed fair value will occur, or how far the currency can continue to diverge from that fair value. Short-term basis risk matters even to long-term investors, simply because the biggest currency moves tend to happen very suddenly.
Which instruments to use?
Currency hedging is achieved through the use of derivative instruments. The most common instrument used by investors are currency swaps. The underlying forward contracts are often the most practical due to their high liquidity and customizable nature. Some of our institutional investors I deal with, often swap with different banks to mitigate their counterparty risk.
As a nutshell, currency swaps involve agreeing to short an amount of foreign currency at an agreed date for an agreed price and rolling this position over the term of the contract. A common period for forward swap contracts is 90 days, though longer and shorter time periods also apply. Some apply also one month staggered rolling strategies.
Currency hedging can also be carried out with options. A currency option offers exposure to the strengthening of your base currency without saddling you with the exposure to the weakening of your base currency. In exchange, you pay an up-front premium determined by the implied volatility of the exchange rate.
The fat tail you are concerned about hedging, is a pronounced weakening of your exposure currency or strengthening of your base currency. But the premium you have paid for the option will probably have taken that risk into account. Over the long term, when the currency exposure mean-reverts and nets-out to zero overall effect, by definition, a rolling option program is going to cost you to the extent of the premiums you have paid to keep it in place. The option premium is essentially the price of insuring against a decline in a currency below a certain point. I believe that the performance drag explains why institutions don’t systematically hold options positions.
Additionally, the cost of an option can depend on, for example, whether the interest rate differential is to your advantage or not. There are definitely situations where you can lock in better gains and cheaper optionality by using interest-rate differentials or the different volatilities in one tenor versus another. But keep in mind that assessing this approach could be quite a complex process, and that the cost of a dynamic hedging strategy can only be estimated since the cost is related to the transaction costs of the dynamic hedge, which in turn depend on the path that currencies follow during the life of the hedging strategy. The argument in favor of options is that once they are in place you know your costs. But do you know what the cost will be to roll that position into a new contract in one, three or six month’ time, to maintain your hedge?
When the contract expires you face an uncertain and uncontrolled cost associated with implementing a new one. The client is completely exposed to whatever volatility there might be in the market – and, of course, the time when they need protection the most is precisely the time when it’s most expensive!
To hedge or not to hedge foreign currency exposure? That is a question posed repeatedly by investors, and partially answered by their advisers and investment managers. Some will advise to hedge fully. Some will advise to hedge partially with a currency overlay.
As we know, currency management plays an important part in portfolio management, particularly as investors access a greater range of foreign investments. Hedging can help to lower risk in a portfolio and the decision to hedge or not to hedge is often dependent on the characteristics of the asset class being invested in and the risk and return objectives of the investor. While investors in foreign equity may be willing to accept some currency risk and a higher level of portfolio volatility in exchange for a greater potential return, for more defensive asset classes such as fixed income investments, hedging continues to be a major thematic.
Solutions should always be tailored to the needs and wants of the individual investor.
To hedge or not to hedge foreign currency exposure? Since currency exposure can have a significant impact on portfolio returns, investors should consider hedging this risk appropriately and methodically. Even though the answer to this question seems trivial, there is no consensus on how to go about it. Some advisers and investment managers will advise to hedge fully. Some will advise to hedge partially with a currency overlay. Some will implement it via option strategies, others with swaps.
We will shed some lights on how do we go about effectively construct a currency hedging program. This is what this article is all about.