Active Trading Strategies and Tactical Trading Decisions

When managers pursue active trading strategies, they expose themselves to risk. This risk is due to their market views, which may not always be accurate. Additionally, increased transaction costs add to the challenges they face. As a result, managers need to have confidence in their forecasts. The table below outlines the possible forecasts an active manager might have and the corresponding actions to be taken:

$$ \begin{array}{l|l|l} \textbf{Metric} & \textbf{Forecast} & \text{Action} \\ \hline \textbf{Relative Currency} & \text{Appreciate} & \text{Reduce hedge on long currency} \\ \hline & \text{Depreciate} & \text{Increase hedge on long currency.} \\ \hline \textbf{Volatility} & \text{Rising} & \text{Long straddle, strangle} \\ \hline & \text{Falling} & \text{Short straddle, strangle} \\ \hline \textbf{Market Sentiment} & \text{Stable} & \text{Carry trade} \\ \hline & \text{Turmoil} & \text{Unwind carry trade} \end{array} $$

Active managers have flexibility in these strategies. They must decide their level of conviction in their forecasts. Based on their confidence, they make adjustments. For instance, in a short strangle, which bets on decreasing volatility, the manager’s level of conviction determines the strike proximity. A narrower window leads to higher profit when correct. But it also increases the potential for higher losses when wrong.

Notes for currency hedging for portfolio managers:

• If a manager wishes to hedge a long (short) exposure, the manager may short (go long) the underlying’s derivative contract.
• Tradeoffs mean that cheaper hedges don’t always provide the best protection.
• The cost of hedging changes with market conditions (i.e., forward points and implied volatility).
• Natural hedges should be taken into account and used to the portfolios’ benefit when possible.
• There is no foolproof formula or guaranteed way to successfully manage currency risk.
• Hedging can be expensive.
• Cost mitigation methods include: writing options to earn income, varying the strike prices of the options used, varying the notional amounts of the derivative contracts, or using exotic features.

Question

In a hedged position, the portfolio manager is long on THB/AUD and expects the price currency to depreciate. Given this scenario, what is the manager’s most likely course of action?

1. Reduce hedge on long currency.
2. Increase hedge on long currency.
3. Reduce the hedge on the short currency.

Solution

The correct answer is A:

Since the manager believes the price currency will depreciate (meaning the base currency will appreciate), and the manager is already long on the base currency, the appropriate action would be to reduce the hedge on that long currency. This allows the base currency to appreciate without the burden of a short position slowing it down or completely hedging it out.

$$ \begin{array}{l|l|l} \textbf{Metric} & \textbf{Forecast} & \textbf{Action} \\ \hline \bf{\textit{Relative Currency}} & \textit{Appreciate} & \textit{Reduce hedge on long currency} \\ \hline & \text{Depreciate} & \text{Increase hedge on long currency} \end{array} $$

B is incorrect. This would not be the most likely course of action because increasing the hedge on the long currency would mean that the manager is trying to protect against an appreciation of the price currency, which is not what they expect to happen.

C is incorrect. The scenario only mentions a long position on THB/AUD and nothing about a short position or a short currency. Therefore, reducing the hedge on the short currency would not be a relevant course of action in this case.

Derivatives and Risk Management: Learning Module 3: Currency Management: An Introduction; Los 3(e) Describe how changes in factors underlying active trading strategies affect tactical trading decisions