HEDGING WITH FUTURES OR FORWARD CURRENCY CONTRACTS − − − To hedge CR, forward contracts are mostly used also known as currency swaps.. DC = Domestic Currency CRM = Currency Risk Manage
Trang 1“ CURRENCY RISK MANAGEMENT ”
INTRODUCTION
CRM ⇒ a portfolio is subject to ∆ in expectations & risks & CR is one of the most important areas of risk management in international portfolio
CR ⇒ uncertainty in the value of an exposure caused by variability
in the exchange rate
Currency derivatives are used to protect a portfolio against CR
1 HEDGING WITH FUTURES OR FORWARD CURRENCY CONTRACTS
− − −
To hedge CR, forward contracts are mostly used (also known as currency swaps)
Expected inflow (outflows) of FC can be hedged against depreciation (appreciation) of FC by entering into
a forward contract to sell (buy) that currency
Contract size = MV principal of the assets to be hedged
% return on the assets in FC is simply the holding period return
Unhedged domestic return = ౪ ౪ బ బ
బ బ
౪ ౪ బ బ
బ బ − ౪ బ బ బ
బ బ where:
& = Portfolio value in FC at time 0&t
& = Spot exchange rate at time 0&t
& = Future exchange rate at time 0&t
Translation loss (unhedged position) = % return in FC-unhedged return in DC
Due to principal only hedging, translation loss is possible on investment gain It can be calculated as:
where
− = ($) return on the future contract if entire investment is hedged
− = $ return on the futures when only principal is hedged
The amount of currency to be hedged requires periodic adjustments (to reflect ∆ in the value of the position to be hedged)
Yield accrued in FI securities can be currency hedged but unexpected capital G/L are subject to CR
DC = Domestic Currency
CRM = Currency Risk Management
FC = Foreign Currency
Minimum-Variance Hedge Ratio
If FC investment represents a fixed deposit, selling an equivalent amount currency forward can eliminate
CR
This ratio minimizes the variance of the return on the hedged portfolio:
Hedged portfolio return = unhedged DC return-(hedge ratio ×∆ in futures price) or =∗−ℎ ×
Optimal hedged ratio ⇒ used to minimize the variance of :
ℎ∗= ∗− ⁄
=
⁄ =1+ ⁄ where 1= translation risk & remaining portion is economic risk Where
= variance of exchange rate movements
Trang 2Translation & Economic Risk
G/L from ER ∆ that result from the translation of the value of the
assets from FC to DC
This risk exists even fixed FC deposits
− = % ∆ in exchange rate × (1-h)
Variance −can be minimized if h=1
∆ in competitive position as a result of permanent ∆ in ER
Importing (exporting) country has +ve (-ve) covariance b/w asset return measured in local currency & ER movements
+ve covariance b/w bond’s local currency returns & ER movements
+VE covariance results in double loss to foreign investors (translation loss as well as investment value loss)
Both, translation & economic currency risk should be hedged to protect the portfolio value
When correlation b/w foreign asset’s returns &
short-term currency movements is zero ⇒ hedge ratio should be 1
Basis Risk
Risk that basis (IR differential) will ∆ unexpectedly
Quality of hedge can be affected by movement in IR differential which may have correlation with movement in spot ER itself
Hedged portfolio return (DC) – Portfolio return (FC) = basis
When % ∆ in future ER < (>) % ∆ in spot ER, basis risk -vely (+vely) affects investors
Short term forward ER movement primarily depends on spot ER, IR differential has small effect on short-term futures price
Implementing Hedging Strategies
Transaction costs
Need to be rolled over periodically
Manager can choose from the following strategies:
Short-term contracts
Maturity matched contracts
Long-term contracts, maturity extending beyond the hedging period
Basis risk can be eliminated by matching the contract maturity to investment horizon
Trade-off b/w maintaining a desired hedge ratio & avoiding transaction costs
Better track the behavior
of the spot ER
Trading volume
More liquid
Hedging Multiple Currencies
Cross hedges are used if futures or forward contracts are not available
In order to achieve complete FC hedge, hedge investments in each FC (not feasible for certain
Trang 3Possible Solutions
Portfolio’s historical domestic returns can
be regressed on the futures return for few actively traded currencies ∗= +
ℎ,, +ℎ+ ⋯ + ℎ+ where
∗ = historic domestic returns
ℎ = hedge ratio for currency i
= Futures returns on currency i
Use contracts on a basket of currencies as offered by some banks
In a multi-currency portfolio, residual risk
of each currency is partly diversified away
2 INSURING AND HEDGING WITH OPTIONS
FC call & put options are used as an insurance instrument
Good hedge implies buying options, not selling or writing them
Options protect a portfolio in case of adverse currency movements & maintain its performance potential in case of favorable currency movements (futures hedge in both directions)
Option premium is regarded as sunk costs & prevents a perfect hedge
Gain obtained by paying a lower premium is offset by accepting a strike price for the put option
Dynamic Hedging with Options
Relationship b/w option premium & underlying ER
Fully hedged position ⇒ in portfolio value due to currency movement = in the value of options position
= ∆
Delta tells the no of options that should be purchased to hedge translation risk
Hedge ratio = −1 ()
Translation loss due to FC depreciation = portfolio value ×−
Net profit on the position = net profit on options + translation loss due to FC depreciation
Net portfolio value = domestic portfolio value + net G/L on the options
Appropriate no of options ⇒ gain in option = translation loss
Delta hedge strategy ⇒ no of options held must be adjusted on a continuous basis because delta & hedge ratio ∆ with ER
Transaction costs
To avoid over (under) hedging, the investor must either sell (buy) some puts or switch to options with a () exercise price & () delta
Mixed hedging insurance strategy ⇒ option position is revised only periodically in case of significant ∆ in ER
If option is in-the-money & hedge is lifted before maturity, the profit forgone will be < the premium paid (time value of option)
Expensive (cheap) option offers better (poor) downside protection at the cost of lesser (greater) profit when FC appreciates
When depreciation of FC is very likely (unlikely), in-the-money (out-of-money) put options should be purchased
Trang 4Difference b/w Future & Options
Highly liquid
Symmetric risk-return structure
Low transaction costs
Suitable when ER are volatile but clear view
of direction
Hedge ratio is constants
Asymmetric risk-return structure
Downside protection while allowing profits from upside
Appropriate when direction, timing &
magnitude of ER ∆ is uncertain
Hedge ratio fluctuates
Several maturities & exercise prices
3 OTHER METHODS FOR MANAGING CURRENCY EXPOSURE
Exposure to a foreign market without its currency exposure
For stocks ⇒ buy equities with β & sell equities with
For bonds ⇒ duration of a foreign portfolio without currency exposure
Leveraged instruments on foreign assets e.g stock & bond futures (only margin is subject to CR)
Futures & options are used to currency exposure only when assets are not owned by investors (otherwise use conventional methods of currency hedging)
If investor expects that FC will depreciate & foreign IR will :
Buy long-term or zero coupon bonds
Hedge CR with futures or options
4 STRATEGIC AND TACTICAL CURRENCY MANAGEMENT
Balanced mandate, neutral or long-term policy for currency hedging
Neutral allocation to a currency is decided in the absence of specific opinions on currencies
In the long run, a benchmark hedge ratio is used (in the short run benchmark hedge ratio
violation is possible)
For private (institutional) investors, strategic currency decision is based on IPS (hedge
ratio)
Strategic hedge ratio is based on:
Total portfolio risk ( the portion of international assets in a portfolio, the the
benchmark hedge ratio should be)
Asset types ( the correlation b/w portfolio return & currency movements, the the
hedge ratio)
Investment horizon (inverse relation)
Prior beliefs on currencies (when domestic currency is considered structurally weak,
hedge ratio)
The perceived costs of hedging, the hedge ratio
Hedging cost has two components:
Transaction costs
It involves currency overlay:
CR is often delegated to currency overly manager (currency expert)
Hedge ratio is assigned by investors according to their desired CR
Currency overly manager can be external or among portfolio management team
Approaches in currency overly:
Management of CR profile ⇒ through dynamic hedging
or option-based approaches
Tactical approach ⇒ exploiting temporary market inefficiencies
Fundamental approach ⇒ economic analysis to detect undervalued or over-valued currencies
Asset allocation & currency hedging decision should be simultaneous rather than in two steps as in currency overlay
Approaches to Currency Management
Trang 54 STRATEGIC AND TACTICAL CURRENCY MANAGEMENT
Currency is treated as a special asset class
Asset class is managed independently from the rest of the portfolio
Managers try to generate superior alpha returns through currency investments
Separate Asset Allocation Approaches to Currency Management
Difference b/w Currency Overlay &
Currency as a Separate Asset Class
To hedge an existing portfolio against CR
Focus on attractive risk profile relative to benchmark
Currency Overlay
To generate +ve alpha return
Use LIBOR or other cash benchmark on an absolute return basis
Asset Class