Currency Management

Question 1

What are the arguments made for not hedging currency risk?

Answer 1

1. It’s best to avoid the time and cost of hedging or trading currencies.
2. In the long-run, unhedged currency effects are a “zero-game”; if one appreciates, another must depreciate.
3. In the long-run, currencies revert to a theoretical fair value.

Question 2

What is the argument for active management of currency risk?

Answer 2

In the short run, currency movement can be extreme, and inefficient pricing of currencies can be exploited to add to portfolio return. Many FX trades are dictated by international trade transactions or central banks. These are not motivated by consideration of fair value and may drive currency prices away from their fair value.

Question 3

What are the general currency management strategies and their goals.

Answer 3

1. Passive hedging: Rule based and typically matches the portfolio’s currency exposure to that of the benchmark. The goal is to eliminate currency risk relative to the benchmark.
2. Discretionary hedging: Manager deviates modestly from passive hedging by a specified amount. The goal is to reduce currency risk while allowing the manager to pursue modest incremental currency returns relative to the benchmark.
3. Active currency management: Manager makes greater deviations from benchmark exposures. the goal is to create incremental return (alpha), NOT to reduce risk.
4. A Currency Overaly: Outsourcing currency management. The manager is purely seeking currency alpha, NOT risk reduction.

Question 4

What are the factors that shift the strategic decision formulation toward a benchmark neutral or fully hedged strategy?

Answer 4

1. A short time horizon for portfolio objectives.
2. High risk aversion.
3. A client who is unconcerned with the opportunity costs of missing positive currency returns.
4. High short-term income and liquidity needs.
5. Significant foreign currency bond exposure.
6. Low hedging costs.
7. Clients who doubt the benefits of discretionary management.

Question 5

Describe the Economic Fundamentals active currency strategy and list the factors associated with an increase in the value of a currency.

Answer 5

This approach assumes that, in the long term, currency value will converge to fair value. Increases in the value of a currency are associated with currencies:

1. That are more undervalued relative to their fundamental value.
2. That have the greatest rate of increase in their fundamental value.
3. With higher real or nominal interest rates.
4. With lower inflation relative to other countries.
5. Of countries with decreasing risk premiums.

Opposite conditions are believed to be associated with declining currency values.

Question 6

Describe the Technical Analysis active currency strategy and list the 3 principals that it is based on.

Answer 6

1. Past prices can predict future price movements and because those prices reflect fundamental and other relevant information, there is no need to analyze such information.
2. Fallilble human beings react to similar events in similar ways and therefore past price patterns tend to repeat.
3. It is unnecessary to know what the currency should be worth (based on fundamental value); it is only necessary to know where it will trade.

Question 7

What is the Carry Trade active currency strategy?

Answer 7

A carry trade refers to borrowing in a lower interest rate currency and investing the proceeds in a higher interest rate currency. Three issues are important to understand the carry trade:

1. Covered interest rate parity holds by arbitrage and establishes that the difference between spot (S_0) and forward (F_0) exchange rates equals the difference in the periodic interest rates of two currencies.
2. The carry trade is based on a violation of uncovered interest rate parity.
3. Because the carry trade exploits a violation of interest rate parity, it can be referred to as trading the forward rate bias.

Question 8

What is the Volatility Trading active strategy?

Answer 8

Volatility or “vol” trading allows a manger to profit from predicting changes in currency volatility.

Question 9

What is a cross hedge?

Answer 9

A cross hedge (proxy hedge) refers to hedging with an instrument that is not perfectly correlated with the exposure being hedged.

Question 10

What is a macro hedge?

Answer 10

A macro hedge is a type of cross hedge that addresses portfolio-wide risk factors rather than the risk of individual portfolio assets.

Question 11

What is the minimum-variance hedge ratio (MVHR)?

Answer 11

The MVHR is a mathematical approach to determining the hedge ratio. When applied to currency hedging, it is a regression of the past changes in value of the portfolio to eh past changes in value of the hedging instrument to minimize the value of the tracking error between these two variables. The hedge ratio is the beta (slope coefficient) of that regression.

Question 12

What are the three components of exchange rate risk?

Answer 12

1. Economic exposure - The loss of sales that a domestic exporter might experience if the domestic currency appreciates relative to a foreign currency.
2. Translation exposure - Decrease in value on financials due to translation from foreign to domestic currency.
3. Transaction exposure - The risk that exchange rate fluctuations will make contracted future cash flows from foreign trade partners decrease in domestic currency value or make planned purchases of foreign goods more expensive.