FOCUSING ON RISK MANAGEMENT & INVESTMENT OPPORTUNITIES IN FX
Money is more than a medium of exchange, but also an account and a store of value. As a result, the global currency market serves as an account of value and a numerator for valuing cross-border assets. Flexible and floating exchange rates followed the breakdown of the Bretton Woods exchange system in August 1971. The foreign exchange market is predominantly an over-the-counter market where currency trading takes place. It is one of the largest and most liquid financial markets in the world. The Bank for International Settlement�s (BIS) triennial survey of currency market activity reported daily turnover in traditional foreign exchange markets of $3.2trillion in 2007[1]. The currency market differs from other asset classes such as equities or bonds as foreign exchange investment is a relative rather than an absolute investment decision, where a purchase of one currency requires the sale of another.
The currency overlay industry served an initial purpose of managing the risk from currency exposures inherent in international portfolios. In more recent years, the focus has increasingly been on adding alpha through active currency management[2].
Currency risk is inherent in any portfolio where there is exposure to international assets. One trend in global investment management in recent decades has been to increase international exposures within portfolios, to access a broader array of return streams and to diversify risk. However, by doing so, investors become subject not only to the movement of the markets in which they have invested, but also to any movements in the exchange rates of those markets. So, while portfolio volatility may initially be reduced through geographical diversification, additional risk related to foreign exchange exposures will be introduced.
For example, a U.S. investor may decide to overweight portfolio exposure to European equities. The actual returns received from the investment will not only be affected by the performance of the underlying asset, but also by any changes in the EUR/USD exchange rate. Any gain, therefore, from the asset exposure could be mitigated by Euro depreciation against the U.S. Dollar.
The impact of currency fluctuations on the value of a portfolio�s assets can be dramatic. For example, Euro-area investors who invested in U.S. markets were subjected to significant currency related underperformance when the Euro strengthened against the U.S. Dollar by 45% from 2002 to 2004 and by 35% from 2006 to early 2008[1].
Taking another example, whereby a UK investor added Microsoft stock to their portfolio in December 2005, the table in Figure 1 shows that while the share price in U.S. Dollars increased in value by 36.1% over the two year period between 2006 and 2007, the depreciation of the U.S. Dollar against the British Pound over that period effectively halved the total return achieved, to 18.2%.
Currencies are volatile and will impact portfolio returns translated into base currency. Figure 2 charts monthly high-to-low percentage fluctuations of the Australian Dollar, Euro (German Mark pre-1999), British Pound and Japanese Yen against the US Dollar for the twenty years from 1989. Regardless of the currency, the exchange rate can be seen to witness monthly high-to-low ranges in excess of 4% on average, with a 2.3% standard deviation and extremes of between 16% and 29% across the individual currencies over this time period.
Historically, currency risk has been underestimated or even ignored by international investors, with many believing that the effects of currency would �wash out� over time. While this may be true over the long term, many investors� time horizons are much shorter and the fluctuations that occur during this time may cause unacceptable losses and volatility in return streams.
Figure 3 illustrates the impact of currency risk in both international equity and bond portfolios. If a U.S. based investor held an international equity portfolio benchmarked in U.S. Dollars (using the MSCI World Index, ex-U.S. to represent such holdings), the overall volatility of that portfolio for the period from January 1996 to June 2009 was 17.08%. Excluding any currency impact, the volatility was 15.58%. Hence, the contribution to risk directly from currency exposure was approximately 10% of the total. Currency risk even represents the main contribution to bond portfolios, given the lower volatility of the underlying asset. In a portfolio of international bonds, as illustrated (using the JP Morgan Global Bond Index, ex-U.S.), the contribution from currency as a percentage of the total risk in the portfolio rises in excess of 60%. Similar results are observed if looking at international equities and international bonds in other base currencies, showing that all investors face similar risks associated to currency exposures.
It should be noted that this analysis only refers to risk and not the potential return impact to the portfolio. The result for the investor if this risk is not managed is that currency is an additional source of risk with random returns.
When managing currency risk, an international investor has to deal with two parallel sets of issues:
(1) How much currency risk does the investor wish to have in their international asset portfolio?
The answer will determine the strategic exposure to currencies within the international portion of the investor�s portfolio. By choosing a hedge ratio, the investor reflects the desired, �optimal� neutral benchmark currency exposure. This ratio can range from 0% (un-hedged) to 100% (fully hedged). Any hedging will typically involve the rolling of currency forwards to maintain the chosen hedge ratio. Partial hedging strategies are often considered given the potential high cost cash flow implications of a high hedge-ratio passive strategy.
(2)Does the investor wish to supplement this strategic neutral benchmark exposure in the portfolio with an additional tactical active currency management program?
In this case, the investor would allow an active currency overlay manager to passively hedge the underlying currency exposures to the benchmark hedge ratio and seek to generate an excess return within pre-agreed guidelines. For example, a 50% hedge benchmark with +/-50% symmetric deviation would allow the investor�s effective hedge ratio to deviate between un-hedged and fully hedged through the active component of the overlay strategy.
The extent to which currency exposure is left un-hedged affects the overall risk profile and returns of a global portfolio. Studies[4] have shown that investors achieve optimal diversification from un-hedged currency risk when the foreign currency exposure represents around 15% of the overall portfolio. However, when the exposure exceeds this amount, the additional volatility experienced begins to swamp the diversification benefit and hence a hedging strategy becomes appropriate.
The optimal hedge ratio is determined through the consideration of a number of points:
The optimal passive currency hedge ratio may be defined as the hedge ratio that maximises the return of the overall portfolio over its risk. In other words, the optimal currency hedge ratio allows investors to reap diversification benefits without the latter being offset by higher volatility.
The optimal neutral hedge ratio has been the subject of quantitative studies[5]. Conflicting conclusions have been drawn depending on the time period used for currency returns and the assumption that past currency behaviour will be replicated in the future. A reasonable solution is to follow a pragmatic approach that takes into account the historical evidence but is not exclusively driven by it. The typical result is a benchmark that lies somewhere between 50% and 70% hedged.
A 50% hedged benchmark is often referred to as the ratio of �least regret�. In this scenario, if the base currency appreciates, a 50% hedged benchmark would benefit from half of that appreciation. Conversely, if the base currency depreciates, a 50% hedged benchmark would benefit from half of that depreciation through the 50% un-hedged portion.
Once the �benchmark� hedge ratio has been chosen, the investor can decide whether to combine this risk reduction strategy, through passive currency overlay, with an alpha seeking program via an active currency overlay strategy;
A pure passive mandate will involve implementing the chosen hedging strategy by taking the underlying foreign exchange exposures in the portfolio and hedging them back to the investor�s base currency, usually through the use of 1-month to 3-month rolling over-the-counter (OTC) currency forward transactions. No active views are taken.
It should be noted that the cash flow ramifications of running a high hedge ratio can be significant. A depreciation of the base currency could lead to a realisation of hedging losses when the forward contracts are rolled. While this is likely to be offset by gains in the currency component of the underlying international assets, such profit would be unrealised and therefore could not be used to fund the currency hedge in the case of a loss.
By implementing an active currency overlay strategy, the underlying portfolio of currency exposures is managed independently from the underlying assets. This strategy is often carried out by a specialist currency manager who will work with the investor to determine the most effective way to achieve this.
The active currency overlay manager, on the one hand, implements the chosen hedge ratio (risk reduction) and uses it as the neutral position when there are no active views, and on the other hand seeks to add alpha from active currency exposures within pre-defined guidelines (return enhancement). The returns of the international portfolio with the chosen hedge ratio (benchmark) will serve as the basis for performance measurement for the active currency overlay strategy.
The guidelines for the active strategy must be set in such a way to ensure efficient excess return generation. Millennium Global views this as best achieved with:
Active currency overlay strategies can be implemented in two ways:
Currency overlay strategies are typically unfunded currency management programs whereby the mandate incorporates both the investor�s desired benchmark hedge ratio (the passive component) and the excess return target (for the active component).
Prior to the inception of such a program, an overlay Investment Management Agreement (IMA) is signed by the manager and the investor. This specifies the chosen benchmark hedge ratio for the passive component and sets parameters for the management of the active component of the overlay mandate. Such parameters may include target returns, permitted currencies, permitted instruments and leverage constraints.
Upon the inception of the program, there may be small cash requirement (often between 5% and 8%) as a deposit to enable the account to operate, to:
(a) Meet potential cash requirements related to passive hedge trade rolls within the passive hedging strategy. The new spot rate is unlikely to be the same as the maturing forward rate, and consequently will result in a positive or negative cash flow on monthly or quarterly settlement dates.
(b) Open positions within the active overlay account. An example would be for the funding of premium payments where an investment manager is able to use options within the active overlay program.
The segregated account is used for the implementation of the chosen hedge ratio where applicable. Guidelines will determine whether the actual currency exposure within the underlying portfolio or that of the underlying asset benchmark ought to be hedged, what tools are used (e.g. 1-month or 3-month OTC currency forwards) and the tolerable tracking error and rebalancing rules.
Pooled vehicles offer easy access for investors seeking currency alpha through active currency management, especially those who might be constrained in the implementation of active overlay strategies from a regulatory perspective*. An important difference to overlay through a segregated account is that the currency pooled vehicle is a funded investment, which may have asset allocation implications for the investor. The pooled fund returns will incorporate interest earned on the cash invested.
The size of the investment in a currency pooled vehicle is generally calculated on a risk-adjusted basis. For example, should the investor seek a 2% excess return at overall portfolio level (e.g. on 100% of the notional international portfolio) from active currency management with an anticipated volatility of 3%, the investment of 10% of the notional portfolio value in a currency pooled vehicle with a target volatility of 30% typically achieves the same result.
*Regulatory restrictions on the use of derivatives may vary from one region to another and some pension plans may not be permitted to use such instruments on a segregated account basis; a pooled fund solution may be an alternative solution. Investors should seek advise from their own legal advisers.
The size of the global currency market can overstate its level of efficiency. The currency market is indeed one of the largest and most liquid markets in the world. However, despite its liquidity, the currency market remains inefficient as a result of a distinct set of non-profit seeking participants, which provides ongoing alpha generating opportunities for active participants, namely:
The BIS Triennial Central Bank Survey 2007 revealed that over the previous three years, there had been an �unprecedented rise in activity in traditional foreign exchange markets� [1]. From April 2004 to April 2007, the average daily turnover in these markets grew by 69% to $3.2 trillion.
Figure 4 demonstrates not only the strong growth in overall Foreign Exchange volume over the past 15 years, but also the considerable percentage of flow that continues to be represented by non-profit seeking participants, i.e. non-financial institutions. As shown below, more than 60% of foreign exchange flow in today�s currency markets is from non-profit seeking participants.
Through their activities, these non-profit seeking participants leave opportunities that skilled currency managers can exploit. To the extent that there are strong theoretical reasons to support the existence of alpha in currency markets, it is reasonable to expect that alpha will continue to be generated in the future. The body of evidence which substantiates currency managers generating alpha over time includes studies from both consulting firms and academics[8].
The ongoing analysis of a representative universe of 16 leading active currency overlay managers by BNY Mellon Asset Servicing shows that currency overlay managers have added value over the longer term. For different time periods ranging from 1-year to 10-years to 31 March 2009, it can be seen that the median manager achieved up to 40bps in excess return while the 25th percentile manager returned up to 100bps.
Between 2004 and early 2007, historically low industrialised interest rates and a turnaround of emerging market current account balances from a deficit to a rising surplus had led to a surge in global liquidity. This fuelled a sharp increase in yield appetite, which led to rising valuations across financial assets, including equity outperformance and bond market spread compression. This environment was associated with record low levels of volatility across asset classes and as a result with a carry approach performing well in global currency markets. However, the bursting of the U.S. housing bubble in 2007 and the global credit crisis that followed triggered a massive de-leveraging, with financial contamination spreading through asset classes. In currency markets, global risk reduction benefited low-yielding currencies as carry trades were unwound. The macroeconomic consequences then unfolded in 2008-09, as credit conditions were severely tightened, with the global economy undergoing the deepest recession since the 1930s. Despite massive monetary and fiscal stimulus and government intervention in the banking sector, the macroeconomic outlook remains very uncertain, owing to the remaining need for banks and consumers to de-leverage, especially in the US and UK.
As a consequence, financial market volatility remains elevated and the case for currency differentiation according to fundamentals has been strengthened, as the risk-adjusted yield offered in carry based strategies is affected by higher underlying volatility. In turn, the quality of each country�s �balance sheet� should increasingly matter for discriminating between currencies against the global backdrop of a sub-par growth environment over the coming years.
Figure 5 below demonstrates the levels of 1-month implied volatility across a selection of major currency pairs from 1998 to 2009, namely USD/JPY, EUR/USD and AUD/USD, plus EUR/GBP as a representation of non-USD major currency pairs. The broad decline in currency implied volatilities to exceptionally low levels through 2006 into early 2007 is clearly evident, as is the explosion in implied volatilities during the turbulent financial market conditions which followed the Lehman Brothers bankruptcy in Q3-2008. This episode is expected to have lasting impact on the market�s assessment for risk and related asset market volatility. Such conditions are therefore expected to be favourable for currency managers with a more adaptive investment process.
For investors, the need to manage the currency risk inherent in their international portfolios has never been greater. Many are now realising that through an actively managed currency overlay program they can manage their risk and at the same time potentially add an additional return stream at relatively low cost. By using currency forward contracts and OTC currency options, a currency overlay manager can hedge the currency risk or seek to add value without effecting the underlying asset allocation. This means that investors are able to focus fully on security selection, for example, without worrying about forecasting currency trends.
The approach to currency management has evolved. Over recent years, investors have become increasingly aware of the diversification benefits of currency as an asset class in its own right. Active currency returns typically have a low correlation with other sources of alpha and can have information ratios that are equal or even more attractive. Consequently, currency alpha programs, where the passive and active currency management elements are separated, have become more commonplace.
Any portfolio with exposure to international assets will be subject to currency risk. A certain amount of un-hedged currency risk within a global portfolio offers diversification benefit. However, beyond limits the additional volatility experienced from currency risk within a portfolio can serve to swamp this diversification benefit. Indeed, currency can even represent the main contribution to risk. The issue for international investors is identifying an optimal way to manage that risk. While it is possible to simply ignore the currency exposures inherent in an international portfolio, it is highly likely that the end result will be that the unmanaged risk results in random returns.
Implementing an active currency overlay program has two potentially favourable outcomes � firstly, reduction in underlying risk through a benchmark passive hedge that maximises the return of the overall portfolio over its risk and, secondly, capturing an additional return stream through active management around that benchmark.
Setting up an active currency overlay mandate is relatively straightforward when working with an experienced currency overlay manager and is unlikely to disrupt the management of the underlying portfolio. The passive component of a currency overlay mandate is implemented with a currency overlay manager through a bespoke passive hedge, whilst the active component can be implemented through either a bespoke unfunded segregated account, via a custodian or prime broker arrangement, or a funded currency alpha pooled vehicle.
The size of the currency market belies its efficiency. As a liquid and transparent product, transaction costs in currency markets are relatively low and the existence of a distinct set of non-profit seeking participants in the currency market leaves opportunities for skilled alpha seeking currency managers to exploit. Analysis has shown that currency overlay managers have added value over the longer-term and that active currency returns typically have a low correlation with other sources of alpha.