Exchange Rate Influence

Accumulation and Spending of Resources

Managing wealth involves the strategic accumulation and spending of resources. Some families operate within a single country, using a single currency, while others have a more global footprint, with assets spread across various jurisdictions and currencies. This global approach introduces exchange rate risk, which wealth managers must address. A common strategy is geographic diversification, particularly for families with assets in multiple jurisdictions. Stable political regimes and currencies are often preferred investment locations.

Reasons for Global Asset and Liability Distribution

• Opting for favorable tax regimes: For instance, a family residing in the United States, a high-tax jurisdiction, might choose to invest in Singapore, known for its lower tax rates on income and capital gains.
• Guarding against inflation or deliberate currency devaluations: Countries like Japan, with independent central banks and low inflation mandates, offer a degree of protection against these risks.
• Ensuring legal protection against third-party claims: Jurisdictions like the United Kingdom, with its efficient common law system, offer strong legal protections for investors.
• Shielding assets from governmental confiscation: Countries with strong private property rights and robust legal systems, such as Canada, offer protection against this form of political risk.

Strategies, Goals, and Associated Risks

While certain strategies aim to achieve specific goals, they may inadvertently introduce new risks. For example, investors who located assets in Cyprus in 2013 for its legal protections and modest tax rates were later subjected to capital controls due to a banking crisis triggered by the Greek debt crisis.

The family extended balance sheet is a useful tool for identifying and mitigating exchange rate risk through strategic planning.

Understanding Exchange Rate Risk in Wealth Management

The concept of a family’s wealth is fundamentally based on the surplus of its real and financial assets over its projected liabilities. This surplus can be influenced by various risks, one of which is exchange rate risk. This risk becomes particularly significant for affluent families with a global presence and diverse income and expense streams, as they face increased complexity in making currency decisions.

The impact of currency mismatches on the management of assets and liabilities can be detrimental, especially over the long run. For instance, consider a wealthy American family residing in Germany, earning and spending in euros, but planning for future expenses like children’s education and retirement in the United States, denominated in US dollars. This family would face significant exchange rate risk.

The family’s balance sheet, denominated in US dollars, reveals currency mismatches between assets and liabilities. The risk of that mismatch is compounded by exchange rate volatility. If the euro depreciates relative to the US dollar, the family would suffer a loss of their surplus. The magnitude of the loss depends on the size of the depreciation.

Calculating the Impact of Exchange Rate Fluctuations

The decline in net assets due to exchange rate fluctuations can be calculated using the formula:

$$ \begin{align*} \text{Net Asset Decline} & = \text{Return}_{\text{Base Currency}} \\ & \times (\text{Assets}_{\text{Base Currency}} – \text{Liabilities}_{\text{Base Currency}}) \end{align*} $$

Where:

$$\text{Return}_{\text{Base Currency}} = \frac{S_{t,\text{Price/Base}}}{S_{t-1,\text{Price/Base}}} – 1$$

Here, \(S_{t,\text{Price/Base}}\) is the spot price of the base currency expressed in terms of price currency at time \(t\), and \(S_{t-1,\text{Price/Base}}\) is the spot price of the base currency expressed in terms of price currency at time \(t-1\).

If the assets denominated in the base currency equal the value of the liabilities denominated in the base currency, the family has no risk exposure to the exchange rate between the base currency and price currency.

Managing Exchange Rate Risk

To manage this risk, the wealth manager could recommend several hedging strategies. These could include a passive hedging strategy, which seeks to insulate the family from all currency risk, or a discretionary hedging strategy, which keeps the hedge ratio within a bound. Alternatively, the wealth manager could use a carry trade strategy or seek investments in the base currency that invest in price currency–denominated assets.

Reference (or Price) Currency

The concept of a reference currency is a fundamental aspect of international finance and wealth management. It is particularly relevant for high-net-worth individuals and families with a global presence and diverse financial objectives.

The reference currency is the currency in which liabilities and financial objectives are denominated. For instance, a Japanese investor with assets in the US would likely use the US dollar as their reference currency. This concept is vital in wealth management, especially for globally dispersed wealthy families with liabilities and financial objectives in multiple currencies.

Challenges in Currency Risk Management

• Given the volatility of fiat currencies, maintaining wealth can be challenging as the cost of a luxurious lifestyle often outpaces inflation.
• There is a disparity between the global GDP, increasingly influenced by developing nations, and the universe of investable assets, predominantly concentrated in developed countries.
• Political factors could potentially restrict or deny access to the US dollar payment system.

Factors Inherent to Wealthy Families

• Wealthy families aim to preserve wealth in terms of real purchasing power for future generations.
• These families are becoming increasingly global in their outlook, revenues, expenses, and financial objectives.
• The liabilities of a wealthy family, primarily financial objectives, lack the precision of a pension fund.
• Living in multiple locations throughout the year increases their currency risk.

Currency Hedging

The complexities of external challenges and uncertain liabilities make currency hedging a difficult task. A wealth manager may use a customized basket of currencies that better represents the liabilities and financial objectives of globally dispersed wealthy families.

Reference Currency Basket

If the currency exposure of liabilities and objectives is known, the optimal reference would be a currency basket with weights corresponding to those liabilities and objectives. For instance, if a family’s liabilities and objectives are confined to the Euro, then the Euro would be the reference currency. A globally mobile wealthy family may want to preserve its global purchasing power, in which case the wealth manager can use a currency index with weights based on a macroeconomic factor, such as GDP.

Advantages of Currency Basket Index

• Asset allocation decisions can be made independently of the chosen currency basket as the currency exposure is achieved through the overlay and not through asset allocation.
• Currency allocation becomes more disciplined and systematic.

Practice Questions

Question 1: A wealthy American family is residing in Germany, earning and spending in euros, but planning for future expenses like children’s education and retirement in the United States, denominated in US dollars. They are concerned about the exchange rate risk and its potential impact on their wealth. As their wealth manager, you are considering different strategies to manage this risk. Which of the following strategies would not be an appropriate method to manage the exchange rate risk for this family?

1. Passive hedging strategy, which seeks to insulate the family from all currency risk.
2. Discretionary hedging strategy, which keeps the hedge ratio within a bound.
3. Investing all the family’s assets in the stock market, without considering the currency risk.

Answer: Choice C is correct.

Investing all the family’s assets in the stock market, without considering the currency risk, would not be an appropriate method to manage the exchange rate risk for this family. This strategy exposes the family’s wealth to significant risk, as it does not take into account the potential impact of exchange rate fluctuations on the value of their assets. The stock market is inherently volatile, and investing all assets in it without considering other factors such as currency risk can lead to significant losses. Furthermore, this strategy does not provide any protection against the risk of the euro depreciating against the US dollar, which could reduce the value of the family’s assets when converted back into US dollars for their future expenses. Therefore, this strategy is not suitable for managing the exchange rate risk for this family.

Choice A is incorrect. A passive hedging strategy, which seeks to insulate the family from all currency risk, could be an appropriate method to manage the exchange rate risk for this family. This strategy involves hedging all foreign currency exposure, thereby eliminating the impact of exchange rate fluctuations on the value of the family’s assets. This can provide a high level of protection against exchange rate risk, although it may also limit potential gains if the euro appreciates against the US dollar.

Choice B is incorrect. A discretionary hedging strategy, which keeps the hedge ratio within a bound, could also be an appropriate method to manage the exchange rate risk for this family. This strategy involves adjusting the hedge ratio based on the wealth manager’s views on the future direction of exchange rates. This can provide a balance between protecting the family’s assets from exchange rate risk and allowing for potential gains if the euro appreciates against the US dollar.

Question 2: The American family residing in Germany has their balance sheet denominated in US dollars. If the euro depreciates relative to the US dollar, what would be the impact on the family’s wealth?

1. The family would suffer a loss of their surplus.
2. The family would gain an increase in their surplus.
3. The exchange rate would have no impact on the family’s surplus.

Answer: Choice B is correct.

If the euro depreciates relative to the US dollar, the American family residing in Germany would gain an increase in their surplus. This is because the family’s wealth is denominated in US dollars, and a depreciation of the euro relative to the US dollar means that the value of the US dollar has increased relative to the euro. This means that the family’s US dollar-denominated assets are now worth more in euro terms. If the family were to convert their US dollar assets into euros, they would receive more euros than before the depreciation. This increase in the value of their assets in euro terms would result in an increase in their surplus. This is a basic principle of foreign exchange – when the currency in which your assets are denominated appreciates relative to another currency, the value of your assets increases in terms of that other currency.

Choice A is incorrect. The family would not suffer a loss of their surplus if the euro depreciates relative to the US dollar. As explained above, the depreciation of the euro would actually result in an increase in the family’s surplus, as their US dollar-denominated assets would be worth more in euro terms.

Choice C is incorrect. The exchange rate would indeed have an impact on the family’s surplus. Exchange rates are a key determinant of the value of assets denominated in foreign currencies. In this case, the depreciation of the euro relative to the US dollar would increase the value of the family’s US dollar-denominated assets in euro terms, resulting in an increase in their surplus.

Glossary

• Exchange rate risk: The risk that the value of an investment will decrease due to changes in exchange rates.
• Geographic diversification: A strategy that involves spreading investments across various geographic regions to reduce risk.
• Capital controls: Measures taken by a government to limit the flow of foreign capital in and out of the domestic economy.
• Exchange Rate Risk: The risk of an investment’s value changing due to changes in currency exchange rates.
• Base Currency: The first currency quoted in a currency pair. It is also typically the currency in which an investor or issuer maintains its book of accounts.
• Price Currency: The second currency in a currency pair. It is used to value the base currency.
• Reference Currency: The currency in which liabilities and financial objectives are denominated.
• Currency Hedging: A strategy used to protect against the risk of losses that result from changes in currency exchange rates.
• Reference Currency Basket: A mix of currencies with weights corresponding to an investor’s liabilities and objectives.

Private Wealth Pathway Volume 2: Learning Module 5: Preserving the Wealth;

LOS 5(d): Describe how exchange rates influence asset allocation and planning as well as approaches to mitigate the exchange rate risk