Strategic Choices in Currency Management

Strategic Choices in Currency Management

The approach to managing currency risk in a portfolio varies widely among participants. Some choose not to take action, believing that long-run returns will eventually mean- revert. On the other end of the spectrum, some participants see an active management opportunity. This is informed by their belief that markets are not entirely efficient.

Do Nothing                  Full Speculation []                        []

Approaches to Currency Management

  • Hedge all the currency risk.
  • Leave portfolios unhedged against currency risk.
  • Use currency risk to enhance portfolio returns.
  • Trade foreign exchange actively.
  • There is no agreement on the most effective way to manage currency risk.

Setting Parameters – Real-World Constraints

In real-world scenarios, currency management is subject to various constraints that influence investors’ approach. These constraints can vary widely, encompassing factors such as stakeholders’ attitudes and the availability of capital, ultimately shaping the strategies employed to manage currency risk.

The Investment Policy Statement

The first place to look for real-world constraints in managing portfolio currency risk is the Investment Policy Statement (IPS). The IPS plays a crucial role in guiding decisions related to hedging currency risk. It includes specific sections that address various aspects of currency risk management, such as:

Investment Policy Statement

The IPS (Investment Policy Statement) plays a crucial role in quantitatively defining how currency risk will be managed in the portfolio. This is typically articulated through various factors, including:

  • The targeted size of exposure is to be hedged.
  • The level of flexibility surrounding management decisions.
  • The timing of rebalancing hedges.
  • Acceptable currency hedge benchmarks.
  • Permissible hedging tools to be utilized.

Portfolio Optimization

Calculating an efficient frontier for a multi-currency portfolio can be challenging due to the need for multiple opinions on expected risks, returns, and correlations of currency pairs. To simplify the process, real-world practice typically breaks it down into two steps.

In the first step, the portfolio manager selects the portfolio weights (ωi) for the foreign-currency assets that optimize the expected risk-return trade-off of the foreign-currency assets, assuming no currency risk.

In the second step, the portfolio manager determines the desired currency exposures for the portfolio and decides how far to relax the constraint to achieve a full currency hedge for each pair.

As shown previously, the formulas for currency portfolio expected risk and return are used to quantify the expectations and create a mean-variance efficient portfolio.

Diversification Considerations

Two key themes emerge when deciding how to manage currency risk in a portfolio: time horizon and portfolio composition.

Time horizon plays a significant role in determining the extent to which currency risk should be hedged. Some proponents of the “doing nothing” approach believe that currencies will mean-revert to their long-run values due to interest rate and exchange rate parities preventing arbitrage. However, the duration over which currencies may deviate from their long-run no-arbitrage prices can be much longer than most investors are willing to endure, possibly spanning decades. An impatient investment committee may lead to a shift from a passive “do-nothing” approach to an active currency management style.

Portfolio composition refers to the asset classes in which the underlying foreign currencies are invested. Portfolios with exposure to fixed-income assets often exhibit a greater desire to hedge currency risk. This is because fixed income and currencies tend to fluctuate similarly in response to interest rate movements. In such cases, managers of fixed-income portfolios may choose to hedge the currency risk to avoid waiting for two sources of return to drop simultaneously. On the other hand, equities are more influenced by changes in expected earnings rather than interest rates. This makes equity portfolios less likely to be fully hedged than fixed-income ones.

Cost Considerations

Hedges, much like insurance products, come with costs. Those who advocate for the no-hedge approach often emphasize these associated expenses. When initiating a currency hedging program, various costs may be involved, including:

Cost Considerations

Opportunity costs are an essential consideration in currency hedging strategies as they arise from the possibility of missing out on favorable currency movements. These costs represent the potential gains that could have been realized if the currency had been left unhedged and appreciated. When deciding whether to implement a currency hedge, investors must carefully weigh the benefits of risk reduction against the opportunity costs associated with potentially forgoing favorable currency fluctuations.

Commonly used Strategies

Passive Hedging

Passive hedging is an approach used to manage currency risk in a portfolio. It entails matching the currency exposure of the underlying assets to that of a specified benchmark portfolio. The objective is to keep the currency exposure aligned with the benchmark without actively making decisions based on market views or forecasts. The approach is rules-based. If the currency exposure deviates from the benchmark beyond a pre-determined threshold, the portfolio is rebalanced to align it with the benchmark. This strategy aims to replicate the benchmark’s currency exposure. It may involve periodic adjustments to maintain the desired level of hedging.

Discretionary Hedging

Discretionary hedging is an extension of the passive hedging approach. It grants a portfolio managers greater flexibility in deciding how much they may deviate from the benchmark portfolio.

Active Currency Management

Active currency management extends beyond discretionary hedging, giving portfolio managers greater control over hedging decisions. Managers can express directional biases and engage in currency speculation to potentially enhance portfolio returns. However, even in highly discretionary portfolios, there are usually some minimum constraints on management decisions to prevent significant losses.

Currency Overlay

Currency overlay is a strategy that involves outsourcing the task of hedging currency risk to an external firm. This approach is often considered beneficial when the external firm specializes in managing currency risk and related decisions. The outside consultants are given a considerable level of flexibility, and this approach is generally categorized as active management.

Summary of Strategies:

  1. Passive Hedging: Using a benchmark portfolio and maintaining currency exposure similar to the benchmark with limited deviation.
  2. Discretionary Hedging: Building on passive hedging but allowing the portfolio manager more leeway in deciding the extent of deviation from the benchmark.
  3. Active Currency Management: Extending from discretionary hedging, this strategy allows portfolio managers to control hedging decisions, expressing directional biases and using currency speculation to enhance portfolio returns.
  4. Currency Overlay: Hiring an external firm with expertise in currency risk management to hedge currency risk. This approach falls on the active management end of the spectrum.

Currency Hedging Strategies

Question

Which of the following is least likely an argument favoring a passive-hedging strategy?

  1. A portfolio has an infinite time horizon.
  2. A portfolio consists mainly of fixed-income securities.
  3. Neither of the above is correct.

Solution

The correct answer is A.

Passive hedging is positioned on one end of the spectrum, advocating for stringent controls over currency risk. In this approach, stakeholders typically view currency risk as detrimental to the portfolio and believe that hedging is not overly expensive.

A portfolio with an infinite time horizon, such as many foundations, may be managed by stakeholders who believe that currency prices tend to revert to their long-run values over time. They may argue against implementing tight hedge controls, as they expect the currency risk to naturally correct over the extended lifespan of the portfolio.

B is incorrect. A portfolio heavily invested in fixed-income securities is more likely to be hedged against currency risk. This is because currency and fixed income often exhibit similar risk characteristics, making hedging a more practical strategy to manage currency fluctuations in such portfolios.

Derivatives and Risk Management: Learning Module 3: Currency Management: An Introduction; Los 3(b) Discuss strategic choices in currency management

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Shop Actuarial Exams Prep Shop Graduate Admission Exam Prep


    Daniel Glyn
    Daniel Glyn
    2021-03-24
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    2021-03-18
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.
    Nyka Smith
    Nyka Smith
    2021-02-18
    Every concept is very well explained by Nilay Arun. kudos to you man!
    Badr Moubile
    Badr Moubile
    2021-02-13
    Very helpfull!
    Agustin Olcese
    Agustin Olcese
    2021-01-27
    Excellent explantions, very clear!
    Jaak Jay
    Jaak Jay
    2021-01-14
    Awesome content, kudos to Prof.James Frojan
    sindhushree reddy
    sindhushree reddy
    2021-01-07
    Crisp and short ppt of Frm chapters and great explanation with examples.