, on the [5th]working day of the month, except where speciﬁcally instructed by the Client, or where the Custodian has failed to provide updated portfolio data. [CURRENCY MANAGER] will normally
Appendices
287
receive portfolio information from the custodian by the [4th] working day. In case further rebalancing is to take place it is the Client’s responsibility to inform [CURRENCY MANAGER]timely about expected changes to the investment portfolio to allow [CURRENCY MANAGER]to adjust the overlay programme accordingly. Adjustments to the overlay programme will bemade when the unhedged value of the underlying stock in the market relating to one currencydiffers from the size of the overlay in that currency by more than [3%] of the [sterling] [dollar][euro] amount of exposure. [CURRENCY MANAGER] will set all hedges to expire on the[5th] working day of the month.Cash ﬂowsThe overlay programme will periodically realise positive and negative cash ﬂows upon settlement of the foreign exchange contracts. These settlements will be effected once a month andreduced in size if possible by using ‘settlement netting’ arrangements with the counterparties.Any cash positions may only be held in cash accounts that belong to and are controlled by theClient. [CURRENCY MANAGER] must notify and reconcile the settlement amounts with theCustodian Bank at least two business days prior to the settlement date.Any positive cash ﬂows will be ‘swept’ from the currency overlay portfolio based uponwritten instructions from the Client. Cash requirements to settle foreign exchange contractswill be funded from cash sources at the discretion of the Client.CustodianThe actual underlying investment portfolio will be made available electronically from the Custodian Bank. Further necessary information will be provided by the Client. It is [CURRENCYMANAGER]’s responsibility to monitor the portfolio monthly and to collect the necessarydata from the Custodian and the Client.Further restrictionsAt no time should the net value of all outstanding contracts sold exceed 103% of the underlyingvalue of the assets being overlaid. Forward currency contracts are limited to 13-month forwardsettlement dates or less.[CURRENCY MANAGER] may not deal with any afﬁliated ﬁrms of [CURRENCY MANAGER] as counterparty to any currency contracts.Communications[CURRENCY MANAGER] is responsible for ongoing communication with the Client. [CURRENCY MANAGER] must promptly notify the Client of any signiﬁcant changes to [CURRENCY MANAGER]’s investment or portfolio strategy, organisational structure, ﬁnancialcondition or the personnel managing the portfolio.ReportingMonthly [CURRENCY MANAGER] will issue reports by the 12th working day of the following month as follows:
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Currency Overlay
(a) Monthly overlay valuation report(b) Monthly overlay performance report(c) Bank credit exposure report(d) Monthly transaction and cash ﬂow report(e) Monthly market summary(f) Trailing 12-month and prospective 12-month cash ﬂow report(g) Cash ﬂow at risk report(h) Quarterly Executive SummaryThe report formats will be designed by [CURRENCY MANAGER] based on the Client’srequirements. Semi-annually [CURRENCY MANAGER] will present the performance of theprogramme to the investment committee, and annually to the full Board of Trustees.Investment guideline compliance[CURRENCY MANAGER] will certify in writing, each quarter, that they remain in compliancewith the investment guidelines, and that they have reconciled their transactions that quarter,and the outstanding contract inventory, with the Bank counterparties.If, at any time, [CURRENCY MANAGER] feels that the investment guidelines present animpediment to the investment strategy, [CURRENCY MANAGER] should discuss the matterwith the Client as soon as practical.If, at any time, a speciﬁc guideline is not being adhered to, the Client should be notiﬁedas soon as possible but always within ﬁve business days after the discovery of a breach of aguideline.Addresses and contact personsClient[CURRENCY MANAGER]
Indexaccounting standardsFAS87 11FRS17 13, 98IAS19 13ACT 6, 79active currency overlay 2, 57, 98, 100management styles 205–37surveys 239–40modelling and forecasting 206–12active management without 209–10deal execution 212dealing and practical execution 210judgement and 211timeliness of inputs 210–11‘adding across’ 57–60alpha 107, 208, 211, 244American-style options 37analytical but realistic approach to benchmarkhedge ratio 245annualised returns 83, 85, 267–8, 275–6annualised volatility 83Argentina, ﬁnancial regulation in 80–1asset plus currency overlay methodology 130,131, 136, 145–7Association for Investment Management andResearch (AIMR) 53, 125, 130, 272, 277–85attribution analysis 58autoregressive volatility 226bank contract conﬁrmation 248bank contract settlement procedures 249Bank for International Settlements (BIS) 66bank foreign exchange lines 247–8Bank of England 14banks as customers in foreign exchange market71, 74–5bell-shaped curve 41benchmarks 53, 278–9, 283–4calculation 249–50
cash ﬂows 141–4constant maturity 138currency coverage 140current practice 144–5deﬁnition 125–7denominator coverage 140design 130–44fully hedged 282hedge ratio 133, 139–40, 244–5, 282investability 127–30mechanics 126–7misleading currency attribution 126monthly calculation 132for multi-currency portfolios 280–1original contract maturity 138peer groups (universes) as 279performance 140–1as portfolio 126pricing/costs 136purpose of 125tracking error 148–6unhedged 282–3underlay 140with/without asset returns 135worked examples 145–8bid implied volatilities 51bid/offer spread 2930, 65, 68in futures 35, 37bilateral netting 67BlackScholes model 40–9, 235–6assumptions in option pricing 46–7assumptions violations 48–9costs in 50, 51Greek values 44market assumptions 40–1option pricing 42–6portfolio insurance story 44–6bonds 2, 3, 182–91correlation 182–4
290
Index
bonds (cont.)domestic 3ﬂoating rate 3hedged 182index-linked 3international diversiﬁcation 187–91stability of correlations 185–7volatility reduction from 187zero-coupon 190book value 11bottom-up management 253–4Bretton Woods Agreement 61, 74Buffet, Warren 210capital account 214Capital Asset Pricing Model (CAPM) 99, 208capital ﬂight 78capital ﬂows 62Capital Market Line 99carrier asset 246‘carry trade’ 19, 73, 195, 207, 255central banksas customers in foreign exchange market 74–5declared target exchange rate defence 74–5rejection of FX intervention 75tactical intervention 75Central Limit Theorem 20, 40, 41, 85, 87, 196,197, 225, 269Chartism 74CLS Bank 65, 67, 69conﬂict of interest 257–8constant maturity benchmarks 138continuous adjustment 112Continuous Linked Settlement (CLS) system 69continuous rebalancing 112contract rolling 129contrarian managers 254contribution from hedging 126, 132, 134, 143convexity 84corporate cash ﬂow analysis, limitations of 162correlations between currency returns 219–21costsof benchmarking 136in Black–Scholes model 50, 51in currency swaps 33foreign debt 23–4forward contracts 26–31of futures 35–7of options 50–1passive overlay 117–22rebalancing 117transactions 101–4covered calls 48–9cross hedging 205Cum cash ﬂow USD 131cumulative cash approach 135
currency benchmark with/without asset returns135currency committee 70currency coverage for benchmark 140currency crises 19currency exposure 57economic impact of 21–2embedded 163currency futures 65costs 35–7margining 35nature 34–5sensitivity 37currency options 38, 65nature 37–8pricing 38, 49–51currency overlay managersas customers in foreign exchange market 73–4currency overlay only methodology 130, 134, 148currency overlay performance surveys 239–40Currency Performance Analytics 239currency returns 83, 158, 221currency series 158currency surprise 16–17, 18–19, 53–60, 126, 127,157, 182, 201–2, 281assets and overlay/hedging 58–60assets in a portfolio 57calculation 53deﬁnition 53geometric linking and ‘adding across’ 57–60international assets and spot rate 58spot rates and 54–7currency swaps 22costs 33nature 31–3sensitivity 33–4currency unions 64currency volatility 15–20data mining 213deﬁned beneﬁt (DB) pensions 5–6deﬁned contribution (DC) pensions 6deﬁnition of currency overlay 2delta 44, 45, 51–2, 72, 234delta (dynamic) hedging 40, 234, 235–6delta-hedging currency management (dynamichedging) 212, 234, 235–6denominator calculation for benchmark 140discounted cash ﬂow valuation 10discounting 12in MMV 139tracking error 155disinvesting 54dividend taxes 79dollar pool 15, 79dollar pool premium 15
Indexdomestic bonds 9duration 190dynamic (delta) hedging 40, 234, 235–6dynamic managers 212, 234–7efﬁciencyexecution 65semi-strong 193, 204strong 193, 204transactional 204types of 193weak form 193, 203efﬁcient portfolios 97embedded currency 162embedded currency plus currency overlaymethodology 130, 133–4, 147–8embedded dollars 164Equitable Life 13equities (shares) 2, 3, 157–77base-currency-speciﬁc graphs 174–7GBP base 176–7German/euro base 175Japanese base 174US base 174correlationevidence 158–9historical evidence 157–8international 169stability of 160–2country index equity returns 167–9effect of hedging on portfolio risk 172–3ﬁrm level analysis 162–6volatility reduction 170–1equity return series 158equity returns 158–9ethical managers 254euro 21, 64Euro 75euro baseequities 175‘hammock’ 180, 181Euro-market 62–3European Central Bank 21European Single Currency 21European-style options 37–8Euro-trading 63Eurozone 21exchange controls 75–9conditions for currency market liquidity 77–8control of domestic currencies 76forms 77physical controls 76price intervention 76symptoms of controlled currency economies78–9Exchange Rate Mechanism (ERM) 64, 255
291
exchange rate protection 78execution efﬁciency 65expected rate of return 11–12fair price maths 40FAS87 11fat tails 88–9ﬁxed exchange rate 62ﬁxed mean 224‘ﬂoating rate’ bonds 3foreign assets 20foreign debt 20–1costs 23–4nature 23sensitivity 24–5foreign exchange marketbanks 67basic structure 65–70brief history 61–5clearing mechanism 69–70customer types 70–5customers 67–9exchange controls 75–9ﬁnancial regulation 80–1market size 66physical and regulatory issues 75–81taxation 79–80turnover excluding ‘clearing’ 70foreign exchange (FX) option writers 72foreign exchange (FX) swaps 26, 31forward arbitrage, boundary conditions for263–7forward contractscosts 26–31nature 25–6netting 67sensitivity 31forward currency prices 127forward currency rates 51–2forward rate bias (FRB) 198–202, 218currency risk premium 199–200evidence 199monetary policy and inﬂation 201nominal rate illusion 201–2forward rate bias theory 74fractals 226free lunch 90–7correlation of asset classes 94–7currency exposure and 93–4‘moving parts’ 91–3FRS17 13, 98fully hedged benchmark 125fundamental forecasting 74fundamental managers modelling 212, 213–18future value option premium 229futures-based equitization 97
292
Index
gamma 44, 45, 234GARCH 226, 233Generally Accepted Accounting Principles 20geometric linking 57–60, 129–30German/eurobase equities 175base ‘hammock’ 180, 181gold standard 64growth/value 254‘hair trigger’ model 226Hammerson 191hedge funds 72–3styles 255hedge ratios 177–82current debate 177–82DEM/EUR base ‘hammock’ 180, 181GBP base ‘hammock’ 180, 181–2JPY base ‘hammock’ 179, 180USD base ‘hammock’ 178–9hedge return 126hedge valuation USD 131hedged bonds 182hedged equities 157hedged international 158hedging instruments, range of 258historic volatility 233HSBC 165, 166IAS19 13implied volatilities 46, 51, 72, 230–1, 232imports, rationing of 78income tax 79independent variables 20‘index-linked’ bonds 3individual currency: equity correlations 159–60industrial and commercial companies (ICCs)70–1non-proﬁt-seeking 71proﬁt-seeking 70–1inefﬁciency 258–9cyclical behaviour 194empirical evidence for medium-term trends195–8forward rate bias (FRB) 12, 198–202lack of statistical arbitrage 194–5portfolio 91see also efﬁciencyinformation ratio 207, 224, 225Institutional Investors 3instruments, investor 2–3insurance companiesas customers in foreign exchange market 71–2integration 43interest rate 51–2
differentials 136–7swaps 22, 33International Accounting Standards Board 20International Bank for Reconstruction (IBRD)(World Bank) 61International Foreign Exchange MasterAgreement (IFEMA) 247International Monetary Fund (IMF) 61in-the-money 236intuitive approach to benchmark hedge ratio245investability 127–30investment guidelinesactive 245–6alpha 246–7passive 246Investment Management Agreements (IMAs)123, 248investment managersas customers in foreign exchange market 73–4investment pool traders in FX 72–3invisibles 214Japanbase equities 174yen base ‘hammock’ 179, 181yen ‘carry’ trade 19, 73, 195, 207, 255lagged dependent variable 218, 221Latin Union 64LIBID 24, 52–3LIBOR 22, 23, 24, 52–3life expectancy 3, 4limit orders 122local currency returns 56local return 281lognormal distribution 1lognormal random walk 83–90, 197measurement 83normally distributed period returns 88–9relevance to currency hedging 90returns 84–6test 89volatility 86–8lognormal returns 267–77AIMR 272annualising 275–6industry practice 270investment banks and option traders 273–5literature 273–4MSCI 270–2return 268solution 276–7volatility 268–70lognormality 49–50Long-Term Capital Management 89
IndexMacaulay duration 190Malaysia, exchange controls and 63management styles 253–6active currency overlay 205–37marked-to-market valuation (MMV) 131, 133,138, 138market-makers 68Markowitz, Harry 97, 99mean reversion 224mean-variance optimisation 97–101including currency 97–8methodology 98–101melt-downs 41Minimum Funding Rate (MFR) 98modern portfolio theory 99modiﬁed duration 190momentum managers 254momentum model 226–7monetary isolation 78–9Monte Carlo models 50, 89, 196monthly benchmark calculation 132moving average model 223–6MSCI 271–2MSCI EAFE Index 141, 144, 282multilateral netting 67multiple regression 168negative feedback loop with a lag 194net capital outﬂows 79netting 67netting by novation 67‘no trend’ hypothesis 197Non-Deliverable Forward (NDF) 77normal distribution 41normal variables 20notional borrowing and lending 137Occam’s razor 206offered implied volatilities 51oil and commodity dealers and merchants71one-way ticket effect 284–5option-based managers 212, 229–34option pricing 39–40original contract maturity benchmarks 138out-of-the-money 236overlay managersactive trading 232natural selection of 256–8passive buying 229–32volatility forecasting 232–4over-the-counter (OTC) 38passive overlay 2, 98cash ﬂow 116–17costs 117–22
293
cash ﬂow management 119–21conﬂict of interest and 122–3direct 118–19indirect 119–21rebalancing 119rolling 118mechanics 105–10benchmark/actual asset weights 108–10currencies to be hedged 106–7denominator of ‘contribution from hedging’110frequency of asset valuation 110frequency of cash ﬂows 106original maturity of forward contracts105–6rebalancing 111–16buffer percentage 114–15costs 119delay in 115–16frequency 112–13valuation rates 116Payment-versus-Payment (PVP) system 69pension fund asset valuations 9–10pension fund liabilitydiscount rate 11–13valuations 10–11pension funds 4, 9pensionsdeﬁned beneﬁt (DB) 5–6, 7deﬁned contribution (DC) 6performance measurement 250periodic cash and contract reconciliation 249perverse (‘upward sloping’) demand curve 72plain vanilla options 37, 46–7Plaza Accord 19portfolio optimisation 98–101portfolio volatility 92–3present value (PV) 10pricing/costs of benchmarking 136probability density 42property 191proprietary traders 72–3proxy hedge 109purchasing power parity 215–17purist approach to benchmark hedge ratio 244–5Quantum Fund 73, 255rate matching orders 122rebalancing 111–16benchmark 129, 137–8buffer 153–4buffer percentage 114–15costs 119delay in 115–16frequency 112–13
294
Index
rebalancing (cont.)timing 154–5valuation rates 116regression 215, 221–3reporting requirements 248–9restrictionson active mandate 245–6on alpha mandate 247retirement age 3–4return 266–7returns-based style analysis 280reverse engineering 47rho 44risk-adjusted excess return 225risk-free interest rates 189–90risk-free sovereign debt 189risk reduction 243–4Russell, Frank 240scaleof active mandate 245of alpha mandate 246–7of contracts 129Security Market Line 99semi-strong form efﬁciency 193, 204sensitivity of options 51–2settlement netting 677-standard deviation 41Sharpe, William 225Siegel’s paradox 87–8simulations 227‘simultaneous order’ 28smoothed value 10Society for Worldwide Interbank FinancialTelecommunication (SWIFT) 17, 18Soros, George 72, 73, 255stamp duty 79standard deviation 20‘star’ investors 209stock market crash 1987 45–6straight line hedge 31Strange, Brian 239, 240Strange Report 239strike rate 37strong form efﬁciency 193, 204style analysis 280swaps 21, 22currency 22, 31–4foreign exchange (FX) 26, 31interest rate 22, 33SWIFT codes 18tactical asset allocation 97Taiwan dollar (TWD)proxy hedging of 109passive overlay 101–4, 105–23
targetfor alpha mandate 247on active mandate 246taxation of foreign exchange markets 79–80technical managers, modelling of 212, 219–28technical trading 74Tesco 165theta 44Tobin, James 80Tobin tax 80top-down management 253–4tracking error 107, 130, 148–56, 250dealing prices/benchmark prices mismatch150–2discounting valuations 155hedge ratio variations 153interest rate differential duration 149–50in passive hedging 149–55rebalancing trades 153–5valuation rates for outstanding forwardcontracts 152–3trade options 38tradeable currency 108transactional efﬁciency 204transactions costs, implications of 101–4expected portfolio added value from passivehedging 102–4trends 197UKcross-border portfolio investing in 14–15pound base equities 176–7underlay for benchmark 140unhedge benchmark 125unhedged currency return 135univariate time series analysis 226unofﬁcial currency balances 63‘upward sloping’ (perverse) demand curve 72US dollarbase equities 174base hammock 178–81US Employee Retirement Income Security Act(1974) (ERISA) 11US pension sector, cross-border portfolioinvesting in 14valuationdiscounted cash ﬂow 10of unmatured contracts 133value added 107, 244variation margin 248vega 44very short horizon mean reversion 224volatility 15, 20, 230, 232–4, 268–70annualized 196autoregressive 226
Indexcurrency 15–20drag 268from equities 170–1forecasting 232–4of hedge equities 95historic 232implied 46, 51, 72, 230–1, 232lognormal random walk and 86–8lognormal returns and 268–70portfolio 92–3reduction from bonds 187
295
withholding tax 79WM/Reuters rates 128bank holidays 128closing forward rates 128closing spot rates 128cross rates 128intraday spot rates 128World ex domestic index 170, 171XY graph 153, 154yen ‘carry’ trade 19, 73, 195, 207, 255
Watson Wyatt 240weak form efﬁciency 193, 203wide-horizon (moving average) reversion224
zero-coupon bond 190Index compiled by Annette Musker
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