Chapter 11

1. Chapter 11 Currency Risk Management

2. Introduction • In this chapter we look at: • Hedging with futures and forward currency contracts • Insuring and hedging with currency options • Other methods for managing currency exposure • Currency overlay

3. Hedging with Currency Futures and Forward • Currency futures, forwards and option contracts are primarily used to protect a portfolio against currency risks. • Currency forwards are sometimes referred to as currency swaps. • In this chapter, the generic term futures will denote both futures and forward (or swap) contracts. • The objective of a currency hedge is to minimize the exposure to exchange rate movement.

4. Minimum-Variance Hedge Ratio • One objective is to search for minimum variability in the value of the hedged portfolio. • Investors would like to set the hedge ratio so as to minimize the variance of the return on the hedged portfolio.

5. Minimum Variance Hedge Ratio • The minimum-variance hedge ratio is equal to: where • translation risk hedge is: • economic risk hedge is:

6. Translation Risk and Economic Risk • Translation risk comes from the translation of the value of the asset from the foreign currency to the domestic currency. • A hedge ratio of 1 will minimize translation risk.

7. Translation Risk and Economic Risk • Economic risk comes when the foreign currency value of a foreign investment reacts systematically to an exchange rate movement. • If an investor worries about the total influence of a foreign exchange rate depreciation on her portfolio value, measured in domestic currency, she should hedge both translation and economic currency risk.

8. Optimal Hedge Ratio • The minimum variance hedge is not necessarily optimal in a risk-return framework. • Basis risk affects the quality of currency hedging. • The quality of the hedge can be affected by movement in the interest rate differential (basis) which could be correlated with movement in the spot exchange rate itself.

9. Hedging Strategies • Short-term contracts must be rolled over if a hedge is to be maintained for a period longer than the initial contract. • For long-term hedges, a manager can choose from the following strategies: • rollover of short-term contracts • contracts with a maturity that exactly matches the expected period for which the hedge is to be maintained. • long-term contracts, with a maturity extending beyond the hedging period.

10. Hedging Strategies (continued) • The results of the strategies depend on the evolution of interest rates affecting the basis. • Another consideration is transaction costs. • Longer hedges can be built using currency swaps, which can be arranged with horizons of up to a dozen years.

11. Hedging Multiple Currencies • Cross-hedges are sometimes used for closely linked currencies. • Systematic currency hedging reduces the total volatility of the portfolio. • A complete foreign currency hedge can be achieved by hedging the investments in each foreign currency • This is not feasible for many currencies and is very cumbersome administratively. • Another alternative is to use contracts on a basket of currencies as offered by some banks.

12. Insuring with Options • The traditional method exploits the asymmetric risk-return characteristic of an option, so that it is used as an insurance vehicle. • This approach exploits the greatest advantage of options, namely that an option can be allowed to expire if the currency moves in a favorable direction, hence allowing for a currency gain on the insured portfolio. But the option can be exercised if the currency moves in an unfavorable direction, hence protecting the portfolio against currency looses.

13. Insuring with Options (continued) • The premium is regarded as a sunk cost. • This approach does not allow for a good currency hedge, because of the premium cost, except when variations in the spot exchange rate swamp the cost of the premium.

14. Dynamic Hedging with Options • This approach takes into account the dynamics of the relationship between the option premium and the underlying exchange rate. • A full hedge is a position in which every dollar loss from currency movement on a portfolio of foreign assets is covered by a dollar gain in the value of the options position.

15. Dynamic Hedging with Options (continued) • Hedging strategies with options can be more sophisticated than those with forwards or futures for two reasons: • the hedge ratio of options fluctuates, but is constant for futures; and • an investor can play with several maturities and exercise prices with options only.

16. Other Methods for Managing Currency Exposure • Leveraged instruments on foreign assets, such as foreign stock and bond futures (or options) have little currency exposure because the capital invested in foreign currency (margin or premium) is very small compared to the underlying value of the foreign assets. • The currency movement impact on a combined position of several assets and contracts should be studied carefully.

17. Exhibit 11.6 A Strategy Matrix of Alternative Investments in the U.S. Dollar Fixed-Income Market

18. Currency Overlay • The approach to currency management is specified in the investment policy statement. Several approaches are commonly used: • Balanced mandate — Some clients delegate to the investment manager responsibility for all aspects of international portfolio management, including the currency dimension. The manager is deemed an expert on both assets and currencies.

19. Currency Overlay (continued) • Currency overlay — Some clients delegate the currency management of their international portfolio to a specialized manager, called a currency overlay manager. The composition of the portfolio is transferred to the currency overlay manager who decides on positions taken in currencies and manages currency risk. • Currency as a separate asset allocation — Some clients allocate part of their international portfolio to a specific “currency asset class.” This is an extreme form of currency overlay where this asset class is managed independently of the rest of the portfolio.