Learning Module 3: Currency Management: An Introduction

1. Currency Risk and Return Decomposition

LOS: Analyze the effects of currency movements on portfolio risk and return.

  • Domestic vs. Foreign Assets:
    • Domestic Asset: Trades in the investor’s home currency. Return not affected by FX.
    • Foreign Asset: Denominated in a currency other than the investor’s home currency.
  • Return Decomposition:
    • Domestic-Currency Return (\(R_{DC}\)): Depends on the asset’s foreign-currency return (\(R_{FC}\)) and the percentage movement of the foreign currency against the domestic currency (\(R_{FX}\)).
    • Formula: \[R_{DC} = (1 + R_{FC})(1 + R_{FX}) - 1\]
    • Approximation: \(R_{DC} \approx R_{FC} + R_{FX}\) (if the cross-product is small).
  • Volatility Decomposition:
    • Currency exposure generally increases portfolio volatility unless FX movements are negatively correlated with asset returns.
    • Variance Formula (Single Asset): \[\sigma^2(R_{DC}) \approx \sigma^2(R_{FC}) + \sigma^2(R_{FX}) + 2\sigma(R_{FC})\sigma(R_{FX})\rho(R_{FC}, R_{FX})\]
    • Portfolio Variance: Depends on weights, individual asset variances, FX variances, and all cross-correlations.

2. Strategic Decisions in Currency Management

LOS: Discuss strategic choices in currency management.

  • Investment Policy Statement (IPS): Mandates the hedging policy, benchmark, and trading limits.
  • Strategic Choices:
    1. Passive Hedging: Rules-based. Match portfolio currency exposure to a benchmark (often 100% hedged or 0% hedged). Goal: Minimize tracking error.
    2. Discretionary Hedging: Limited discretion to deviate from the benchmark hedge ratio (e.g., +/- 5%) based on market views. Goal: Protect from risk while seeking modest return enhancement.
    3. Active Currency Management: Broader discretion to take directional currency views. Goal: Generate alpha (excess return) from FX.
    4. Currency Overlay: Outsourcing currency management to a specialist. Can be a pure hedging mandate or an “FX as an Asset Class” mandate (seeking absolute return unrelated to underlying assets).
  • Hedging Considerations:
    • Diversification: Long-term investors may forgo hedging if they believe in mean reversion (PPP). Fixed-income portfolios benefit more from hedging than equity portfolios (correlations differ).
    • Costs: Trading costs (bid-offer spreads, option premiums) and opportunity costs (missing favorable moves).
    • Cost Reduction: Use OTM options or wider discretionary bands.

3. Active Trading Strategies

LOS: Compare active currency trading strategies; Describe how factors affect tactical decisions.

Economic Fundamentals

  • Premise: Exchange rates converge to fair value in the long run but are driven by interest rate differentials and risk premiums in the short/medium term.
  • Base Currency Appreciates If:
    • Long-run equilibrium real exchange rate rises.
    • Real or nominal interest rates rise (attracts capital).
    • Expected foreign inflation rises.
    • Foreign risk premium rises.

Technical Analysis

  • Premise: Historical price data predicts future moves. Markets are not fully efficient; prices reflect psychology (greed/fear).
  • Tools:
    • Trend Following: Moving averages (e.g., Golden Cross).
    • Support/Resistance: Price levels where buying/selling clustering occurs.
    • Overbought/Oversold: Indicators of potential reversals.

The Carry Trade

  • Strategy: Borrow in low-yield currency (funding currency), invest in high-yield currency (investment currency).
  • Basis: Violates Uncovered Interest Rate Parity (UIP). UIP suggests high-yield currencies should depreciate to offset yield advantage. Empirically, they often don’t (Forward Rate Bias).
  • Risk: Negative Skew (crash risk). Carry trades perform well in stable markets but suffer large losses during “flight to safety” events (unwinding).
  • Equivalence: Trading the Forward Rate Bias.
    • Buy currencies at a forward discount (High Yield).
    • Sell currencies at a forward premium (Low Yield).

Volatility Trading

  • Premise: Trade Vega (volatility) rather than Delta (direction).
  • Instruments: Straddles and Strangles (delta-neutral).
    • Long Straddle: Buy Call + Buy Put (ATM). Profits from large moves/volatility spikes.
    • Short Straddle: Sell Call + Sell Put. Profits from stability.
  • Delta Hedging: Continually adjusting the hedge ratio to maintain a net delta of zero, isolating volatility exposure.

4. Trading Tools & Hedging Strategies

LOS: Describe how forward contracts and FX swaps are used to adjust hedge ratios; Describe trading strategies to reduce hedging costs.

Forward Contracts

  • Use: Most common tool for institutional hedging (liquid, customizable, no margin).
  • Static vs. Dynamic Hedging:
    • Static: Hedge set at inception and left alone. Exposure drifts as asset value changes.
    • Dynamic: Periodically rebalancing the hedge to match target hedge ratio.
  • FX Swaps: Used to roll forward contracts. Consists of a spot transaction (to settle maturing forward) and a new forward transaction (to extend hedge).
    • Matched Swap: Spot and forward legs have equal amounts.
    • Mismatched Swap: Spot and forward amounts differ (used to adjust hedge size).

The Roll Yield

  • Definition: Return generated from the difference between the spot rate and the forward rate.
    • Formula: \((F - S) / S\).
  • Profitable (Positive Roll): “Buy Low, Sell High”.
    • Shorting a currency trading at a Forward Premium (F > S).
    • Buying a currency trading at a Forward Discount (F < S).
  • Costly (Negative Roll): Hedging into a currency with a lower interest rate (selling at a discount) generates a negative roll yield (cost of carry).

Currency Options Strategies

  • Protective Put: Buy OTM Put. Cheaper than ATM put but retains downside risk until strike is reached.
  • Risk Reversal: Buy OTM Put + Sell OTM Call.
    • Goal: Fund the put purchase with call premium.
    • Collar: Resulting position limits both downside and upside.
  • Put Spread: Buy OTM Put + Sell deeper OTM Put.
    • Goal: Cheaper protection.
    • Risk: Protection disappears if price falls below the lower strike.
  • Seagull Spread: Put Spread + Sell Call.
    • Use proceeds from selling the call to fund the put spread. Low/zero cost structure.

Cross Hedges & Macro Hedges

LOS: Describe the use of cross-hedges, macro-hedges, and minimum-variance hedge ratios.

  • Cross Hedge: Hedging a currency exposure (Currency A) with a different, correlated currency (Currency B) because direct hedging instruments for A are illiquid or expensive.
    • Risk: Correlation breakdown (basis risk).
  • Macro Hedge: Hedging the aggregate risk of a multi-currency portfolio rather than hedging each currency pair individually. Focuses on broad risk factors (e.g., “Short USD” bucket).
  • Minimum-Variance Hedge Ratio (MVHR):
    • Regression-based approach to minimize portfolio volatility.
    • Often yields a hedge ratio < 1.0 because currency returns and asset returns are often correlated.
    • Formula: \(\beta_{SF}\) from regression \(R_{DC} = \alpha + \beta R_{FX} + \epsilon\).

5. Emerging Market Currencies

LOS: Discuss challenges for managing emerging market currency exposures.

  • Characteristics:
    • Higher Yields: Often attract carry trades.
    • Non-Normal Distributions: “Fat tails” (high kurtosis) and negative skew. Frequent extreme events (devaluations).
    • Liquidity Risk: Markets can seize up during crises.
    • Contagion: Crisis in one EM country often spreads to others.
    • Restricted Convertibility: Capital controls may prevent physical settlement.
  • Non-Deliverable Forwards (NDFs):
    • Used for currencies with capital controls (e.g., BRL, INR, CNY, KRW).
    • Cash-Settled: No physical exchange of currency. Settled in a major currency (usually USD) based on the difference between the NDF rate and the fixing spot rate at maturity.
    • Pricing: Reflects supply/demand and capital controls, often deviating significantly from Interest Rate Parity.