Strategic Decisions

There are a variety of approaches to currency management, ranging from trying to avoid all currency risk in a portfolio to actively seeking foreign exchange risk in order to manage it and enhance portfolio returns.

There is no firm consensus—either among academics or practitioners—about the most effective way to manage currency risk. Some investment managers try to hedge all currency risk, some leave their portfolios unhedged, and others see currency risk as a potential source of incremental return to the portfolio and will actively trade foreign exchange. These widely varying management practices reflect a variety of factors including investment objectives, investment constraints, and beliefs about currency markets.

The Investment Policy Statement

The Investment Policy Statement (IPS) mandates the degree of discretionary currency management that will be allowed in the portfolio, how it will be benchmarked, and the limits on the type of trading polices and tools than can be used.

Most IPS specify many of the following points:

  • the general objectives of the investment portfolio;
  • the risk tolerance of the portfolio and its capacity for bearing risk;
  • the time horizon over which the portfolio is to be invested;
  • the ongoing income/liquidity needs (if any) of the portfolio; and
  • the benchmark against which the portfolio will measure overall investment returns.

For most portfolios, currency management can be considered a sub-set of these more specific portfolio management policies within the IPS. The currency risk management policy will usually address such issues as the

  • target proportion of currency exposure to be passively hedged;
  • latitude for active currency management around this target;
  • frequency of hedge rebalancing;
  • currency hedge performance benchmark to be used; and
  • hedging tools permitted (types of forward and option contracts, etc.).

Currency management should be conducted within these IPS-mandated parameters.

The Portfolio Optimization Problem

Optimization of a multi-currency portfolio of foreign assets involves selecting portfolio weights that locate the portfolio on the efficient frontier of the trade-off between risk and expected return defined in terms of the investor’s domestic currency. 

When deciding on an optimal investment position, these equations would be based on the expected returns and risks for each of the foreign-currency assets; and hence, including the expected returns and risks for each of the foreign-currency exposures. As we have seen earlier, the number of market parameters for which the portfolio manager would need to have a market opinion grows geometrically with the complexity (number of foreign-currency exposures) in the portfolio. 

If the currency exposures of foreign assets could be perfectly and costlessly hedged, the hedge would completely neutralize the effect of currency movements on the portfolio’s domestic-currency return (RDC).

Removing the currency effects leads to a simpler, two-step process for portfolio optimization. First the portfolio manager could pick the set of portfolio weights (ωi) for the foreign-currency assets that optimize the expected foreign-currency asset risk–return trade-off (assuming there is no currency risk). Then the portfolio manager could choose the desired currency exposures for the portfolio and decide whether and by how far to relax the constraint to a full currency hedge for each currency pair.

Choice of Currency Exposures

Strategic Diversification Issues

  • In the longer run, currency volatility has been lower than in the shorter run, reducing the need to hedge currency in portfolios with a long-term perspective.
  • Positive correlation between returns of the asset measured in the foreign currency (RFC) and returns from the foreign currency (RFX) increase volatility of return to the investor (RDC) and increase the need for currency hedging. Negative correlation dampens return volatility and decreases the need to hedge.
  • Correlation tends to vary by time period, providing diversification in some periods and not in others, suggesting a varying hedge ratio is appropriate.
  • Some investors assert that there is higher positive correlation between asset and currency returns in bond portfolios than in equity portfolios. If that is true, then there is more reason to hedge currency risk in bond portfolios than in equity portfolios. In a bond portfolio, the riskiness of the asset and currency are more likely to reinforce each other.
  • The hedge ratio (the percentage of currency exposure to hedge) varies by manager preference.

Strategic Cost Issues: Hedging is not free and benefits must be weighted versus costs.

  • The bid/asked transaction cost on a single currency trade is generally small, but repeated transaction costs add up. Full hedging and frequent rebalancing can be costly.
  • Purchasing options to hedge involves an upfront option premium cost. If the option expires out-of-the-money, the premium is lost.
  • Forward currency contracts are often shorter term than the hedging period, requiring contracts be rolled over as they mature (an FX swap).
  • Overhead costs can be high. A back office and trading infrastructure are needed for currency hedging. Cash accounts in multiple currencies may have to be maintained to support settlements and margin requirements.
  • One hundred percent hedging has an opportunity cost with no possibility of favorable currency movement. Some managers elect to “split the difference” between 0 and 100% hedging and adopt a 50% strategic hedge ratio.
  • Hedging every currency movement is costly and managers generally chose partial hedges. They may hedge and rebalance monthly rather than daily or accept some amount of negative currency return rather than zero.

Locating the Portfolio Along the Currency Risk Spectrum

Currency management strategies for portfolios with exchange rate risk range from a passive approach of matching benchmark currency exposures to an active strategy that treats currency exposure independently of benchmark exposures and seeks to profit from (rather than hedge the risk of) currency exposures. Different approaches along this spectrum include:

Passive hedging is rule based and typically matches the portfolio’s currency exposure to that of the benchmark used to evaluate the portfolio’s performance. It will require periodic rebalancing to maintain the match. The goal is to eliminate currency risk relative to the benchmark.

Discretionary hedging allows the manager to deviate modestly from passive hedging by a specified percentage. The goal is to reduce currency risk while allowing the manager to pursue modest incremental currency returns relative to the benchmark.

Active currency management allows a manager to have greater deviations from benchmark currency exposures. This differs from discretionary hedging in the amount of discretion permitted and the manager is expected to generate positive incremental portfolio return from managing a portfolio’s currency exposure. The goal is to create incremental return (alpha), not to reduce risk.

currency overlay is a broad term covering the outsourcing of currency management. At the extreme, the overlay manager will treat currency as an asset class and may take positions independent of other portfolio assets. Overlay managers can also be given a pure risk reduction mandate or restricted to risk reduction with modest return enhancement.

Formulate an appropriate currency management program

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

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

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