4.4.1 Passive Hedging Currency overlay program ⇒ outsourcing currency risk management task to a firm specialized in FX management.. 4.4.4 Currency Overlay currency risk while active cur
Trang 1“CURRENCY MANAGEMENT: AN INTRODUCTION”
3 CURRENCY RISK AND PORTFOLIO RETURN AND RISK
Domestic asset⇒ asset that trades in the investor’s domestic currency
Foreign asset ⇒ assets denominated in currencies other than the investor’s home currency
FC return ⇒ return of the foreign asset measured in foreign currency terms
DC return ⇒ FC return + % movement in spot exchange rate
where
ி⇒ % ∆ in FC against DC
exchange rate movement, FC asset returns etc.) when forming expectations about future asset price & exchange rate movement
FC = Foreign currency
DC = Domestic Currency
HR = Hedge Ratio
=ி+ி+ிி
ଶ
ଵଵ+ଶଶ ≈ ଵଶ
ଵ + ଶଶ
ଶ + 2ଵଶଵଶଵ,ଶ
diversification
3.2 Volatility Decomposition
risk avoidance to actively seeking FX risk
available to manage currency risk
4 CURRENCY MANAGEMENT: STRATEGIC DECISIONS
IPS mandates the degree of discretionary currency management that will be allowed in the portfolio
4.1 The Investment Policy Statement
locate the portfolio on the efficient frontier of the trade-off b/w risk & expected return defined in terms of the investor’s DC
step process:
4.2 The Portfolio Optimization Problem
Trang 2Many investment practitioners believe that in the long run, currencies have
“mean reversion” feature (i.e un-hedged currency exposure addition does not affect long-run expected portfolio return)
portfolios than for equity portfolios
Intuitive sense ⇒ bonds & currencies react strongly to movements in interest rates
4.3.1 Diversification Considerations 4.3 Choice of Currency Exposures
Optimal hedging decision⇒ to balance the hedging benefits against hedging costs
4.3.2 Cost Considerations
4.4 Locating the Portfolio along the Currency Risk Spectrum
however manager has some limited discretion
4.4.2 Discretionary Hedging
benchmark portfolio
of portfolio manager
4.4.1 Passive Hedging
Currency overlay program ⇒ outsourcing currency risk management task to a firm specialized in FX
management
on future currency movements
function (through overlay) mandates of the portfolio
4.4.4 Currency Overlay
currency risk while active currency manager is supposed
to take currency risk for profit
4.4.3 Active Currency Management
Tactical currency decision⇒ involves active currency management
participants to precisely forecast exchange rates
5 CURRENCY MANAGEMENT: TACTICAL DECISIONS
Trang 3Developing a view about future exchange rate movements based on the underlying fundamentals
Assumptions ⇒ In free markets, exchange rates are determined by logical economic relationships
movement in:
Challenges ⇒ to model movements in real exchange rates & changes in other variables overtime
5.1 Active Currency Management Based on Economic Fundamentals
trade but where they will trade
reversal or correction
positions, entry & exit points
5.2 Active Currency Management Based on Technical Analysis
Carry trade ⇒ strategy of borrowing in low-yield currencies & investing in high yield currencies
Forward rate bias ⇒ forward rates are biased predicator of future spot rate
discount (premium)
The Carry Trade: A Summary Buy/Invest Sell/Borrow Implementing the carry
trade
High-yield currency Low-yield currency Trading the forward
rate bias
Forward discount currency
Forward premium currency 5.3 Active Currency Management Based on the Carry Trade
Reference: Level III Curriculum, Volume 4, Reading 18
Trading style is unique to option markets & is known as volatility trading
Straddle ⇒ combination of both at-the-money put & call
Strangle ⇒ buying out-of-the money put & call
movement in currencies’ implied volatility, are also available
5.4 Active Currency Management Based on Volatility Trading
Trang 4Future or forward contracts on currencies can be used to obtain full currency hedge
investment parameters
6.1 Forward Contracts
6 TOOLS OF CURRENCY MANAGEMENT
market conditions change
Static hedge ⇒ avoid transaction cost but
accumulate unwanted currency risk
Dynamic hedge ⇒ rebalance the portfolio
periodically to manage the currency risk
6.1.1 Hedge Ratios with Forward Contracts
maturity
buying /selling in the market
The Carry Trade and Roll Yield Buy/Invest Sell/Borrow Implementing the
carry trade
High-yield currency Low-yield
currency Earning a
positive roll yields
Trading the forward rate bias
Forward discount currency
Forward premium currency 6.1.2 Roll Yield
Reference: Level III Curriculum, Volume 4, Reading 18
price in future
Protective put ⇒ matching a long position in the underlying with a put option
Option cost is the premium paid to enter into an option (based on its intrinsic value & time value)
6.2 Currency Options
upside potential for hedge
Select Currency Management Strategies Forward Contracts Over-/ under-hedging Profit from market view Option Contracts OTM options
Risk reversals Put/call spreads Seagull spreads
Cheaper than ATM Write options to earn premiums Write options to earn premiums Write options to earn premiums Exotic Options Knock-in/out features
Digital options
Reduced downside/upside exposure Extreme payoff strategies
6.3 Strategies to Reduce Hedging Costs and Modify a Portfolio's Risk Profile
Reference: Level III Curriculum, Volume 4, Reading 18
Trang 5Manager can add incremental value based on market view (subject to IPS permission)
be implemented
(appreciates)
6.3.1 Over-/Under-Hedging Using Forward Contracts
option (e.g 25 or 10 delta option)
It is rational to have a cheaper insurance policy & accept responsibility for minor events
6.3.2 Protective Put Using OTM Options
options
an OTM call option
Risk reversal ⇒ long call & short put in FX markets
6.3.3 Risk Reversal (or Collar)
Put spread ⇒ buying put + writing put
6.3.4 Put Spread
Seagull spread ⇒ long protective put & write both a call & a deep OTM put
6.3.5 Seagull Spread
Vanilla options ⇒ European style put & calls options
Exotic options ⇒ options that are not vanilla
some pre-specified level
6.3.6 Exotic Options
Very similar to hedging single currency but must consider correlation b/w various foreign currency risk exposures
6.4 Hedging Multiple Foreign Currencies
Trang 6Cross (proxy) hedge ⇒position in one asset is used to hedge the risk exposures of a different asset
6.4.1 Cross Hedges and Macro Hedges
cross hedging
6.4.2 Minimum-Variance Hedge Ratio
hedge
All cross hedgers & macro hedges will have to be carefully monitored & rebalanced
to account for the drift in correlation
6.4.3 Basis Risk
Chances of extreme market events & severe illiquidity
issue
7.1 Special Considerations in Managing Emerging Market Currency Exposures
7 CURRENCY MANAGEMENT FOR EMERGING MARKETCURRENCIES
Non-deliverable forwards ⇒ similar to regulated forward contract but these are cash settled
move)
7.2 Non-Deliverable Forwards