Currency Management

FX effects

Return domestic = (1+Return in foreign) * (1+ FX rate) - 1
2 sources of risk= return in foreign and FX rate (use base is the foreign NOT domestic)

Volatility: SD(Rfc)^2+SD(Rfx)^2+2SD(Rfc)SD(Rfx)*Corr

Strategic decisions

IPS will address currency mgmt policy

  • target proportion of FX exposure to be passive
  • active FX mgmt target
  • Freq of hedge re-balancing
  • hedging tools permitted

Time horizon

  • long run belief that FX will mean-revert
  • short run are volatile

Asset composition

  • asset classes have different correlation with FX

Cost considerations

  • Trading costs (bid offer spread, option premiums, admin overhead etc)
  • Opportunity costs

Risk spectrum

  • Passive -> Discretionary>Active>Speculative (view as another asset class)

Currency overlay - exposure is outsourced (passive or active)

Tactical Currency Mgmt Strategies

Econ fundamentals

  • determined by economic relationships that can be modeled
  • Long run driven by PPP
  • Short term driven by IR & inflation differentials as econ performance
  • Real rate + Infl = Nominal rate
  • tight policy -> ⬆ rate

Technical Analysis

  • chart patterns etc

Carry trade

  • borrow in low yield currencies, invest in high yield currencies (high leverage)
  • violates uncovered interest rate parity (fwd rate is unbias future spot rates)

Volatility trading

  • buy options = long vol
  • sell options = short vol

Tools of currency mgmt

100% passive hedge w/ FWDs

  • match MV of foreign exposure with equal offset in FWD contract
  • FWDs quoted in base currency
  • static hedge or dynamic hedge

Roll Yield allows to determine to hedge or not

  • Positive roll = FWD>Spot (If our hedge is SHORT => selling at premium)
  • Negative roll = incline to hedge (if we short FWDs)

Currency options

  • If we long foreign asset => to hedge we LONG PUT (if the base if the foreign, if not we LONG CALL)

Cost Reduction Strategies

  1. Overhedge using FWDs = profit from tatical positioning to offset hedging costs

2. Protective puts using OTM options: 25 or 10 delta options

3. Risk reversal (Collar): buy OTM put, sell OTM call

4. Put spread: buy put, sell deeper OTM put

5. Seagull spread: Put spread + covered call

Hedging multiple currency

  • consider correlation between different currencies

Cross hedge/proxy hedge: position is used to hedge the risk exposure in another (long NZD asset, short AUD asset, +ve corr(aud,nzd)

Macro hedge: focus on entire portfolio (gold -> extreme events, Derivative on index)

Minimum variance hedge: how much to hedge?

  • Asset to be hedge = hedge ratio * hedging asset
  • hedge ratio= Covriance (a,b)/Var of hedging asset

EM Currencies

Challenges

  1. higher trading costs under normal conditions
  2. increase prob of extreme mkt conditions and liquidity under stressed markets

Non-deliverable forwards (NDFs)

  • cash settled in the non-controlled currency, usually USD (not the EM currency)