be further reduced by a technique known as “matched hedging”, whichincreases or decreases the hedge ratio relative to the change in asset allocation. Historically,the act of asset allocation itself within fixed income portfolios has been a major and seemingly
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unavoidable factor in increasing a portfolio’s tracking error. Matched hedging can reducethough clearly not eliminate this.Tracking error can also occur under passive currency management. This is because in orderto implement a passive currency hedging programme a portfolio manager still has to adjust theamount of the currency hedge relative to the value of the underlying as it changes on a regularbasis – i.e. once a month. In reality, many portfolio managers don’t bother to do this. As aresult, the residual that is left over- or under-hedged contributes to the tracking error. In this,the portfolio manager has to balance the transaction costs of re-balancing the currency hedgesagainst the negative effect on tracking error.
8.7 EXAMPLES OF ACTIVE CURRENCY MANAGEMENTSTRATEGIESThere are a wide variety of active currency management strategies that are used in the market,varying at one end of the spectrum from entirely discretionary-based trading to strict rule-basedstrategies. Three prominent strategies that we will look at in this section are closer to the latterrather than the former end of this spectrum:
r Differential forward strategyr Simple trend-following strategyr Optimization of the carry trade
All three of these strategies have consistently added alpha to a portfolio if followed rigorouslyand interestingly have also proven to be risk reducing compared to unhedged benchmarks.Thus, they also help to boost significantly the portfolio’s Sharpe ratio. With what follows, thecontributions and advice of Henrik Pedersen of the CitiFX Risk Advisory Group and EmmanuelAcar of Bank of America’s Risk Management Advisory Group are gratefully acknowledged.8.7.1 Differential Forward StrategyThe core idea behind this is that of “forward rate bias”, or the reality that forward rates arepoor predictors of future spot exchange rates, in contrast to the theories of covered interestrate parity and unbiased forward parity. We have looked at some of the academic backing forthis admission earlier in this chapter, notably by Fama (1984), Kritzman (1993) and finallyBansal and Dahlquist (2000), who suggested that the negative correlation presented by Famabetween future exchange rate changes and current interest rate differentials is crucially linkedto changes in macroeconomic variables.As outlined by Acar and Maitra (2000), the differential forward strategy seeks to takeadvantage of the apparent market inefficiencies as represented by “forward rate bias” byhedging the currency risk only when the interest rate differential is in favour of the hedger. Thatis to say, only when the forward points are at a discount. Conversely, the currency managershould not hedge currency risk when the forward points are at a premium and consequentlythe interest rate differential would reflect a cost. More specifically, when the interest ratedifferential pays the investor to hedge, the currency manager should have a hedge ratio of100%. Conversely, when the interest rate differential costs the investor to hedge, the hedgeratio should be zero. Thus, if the currency manager is operating under a symmetrical benchmark,the manager would go overweight the hedge by 50% when the interest rate differential is intheir favour and underweight by 50% when it represents a cost.
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The results of this strategy have proved to be extremely robust and have been tested acrosssome 91 currency pairs. For the sake of simplicity and clarity, only seven of these are shownin Figure 8.2.Of necessity, when the interest rate differential is favourable, the differential forward strategywill have the same returns as a full forward hedge. Equally, when the interest rate differentialrepresents a cost, the differential forward strategy will have the same returns as an unhedgedstrategy. Thus, overall, the returns of the differential forward strategy will be a function of bothfully hedged and fully unhedged strategies. The advantages of such a strategy are the following:
r As established, it has consistently added alpha for active currency managers.r Equally, it has also reduced risk relative to benchmarks.r The strategy combines the decisiveness of a full hedge with significant flexibility when usedwith a symmetrical benchmark.
r The expected returns of the differential forward strategy are a function both of the expectedreturns of the fully hedged and fully unhedged strategies.Given that the differential forward strategy is based on exploiting the principle of “forwardrate bias”, it must follow to an extent that its expected returns are also a function in turn of theextent of that forward rate bias and thus of the interest rate differential relative to the expectedfuture interest rate differential. For any given interest rate differential, the hedging strategy willperform best when the correlation between the hedged and unhedged returns is more negative.8.7.2 Trend-Following StrategyA second popular strategy for active currency managers is the “trend-following” strategy, whichinvolves using several technical moving averages to provide trading or hedging signals. Activecurrency managers can use this strategy to either trade around their benchmark in order to addalpha, or alternatively to provide a hedging signal. The academic backing for trend-followingstrategies is as deep as that for the differential forward strategy, including works by Bilson(1990, 1993), Taylor (1990), LeBaron (1991) and Levich and Thomas (1993), which showedthat these strategies can indeed produce consistent excess returns over sustained periods oftime. I would suggest however that the seminal breakthrough in this area came in the formof the note by Lequeux and Acar (1998), which gave the strategy more specific properties bysuggesting that in order to be representative of the various durations followed by investors anequally weighted portfolio based on three moving averages of 32, 61 and 117 days would bemost appropriate. Simply put, the core idea behind this strategy is to go long the currency pairwhen the price is above a moving average of a given length and to go short the currency pairwhen it is below. More specifically, if the spot exchange rate is above all three moving averages,hedge the foreign currency exposure 100%. If it is above only two out of the three movingaverages, hedge one-third of the position. In all other cases, leave the position unhedged.ExampleFor instance, consider the example of a Euro-based portfolio manager who invests in USequities and fixed income. In order to allow the potential for adding alpha, the portfolio managerhas given a mandate to an active currency overlay manager, who is allowed to operate undera symmetrical currency hedging benchmark, which gives the most flexibility for providingthat alpha. Using a trend-following strategy, the currency overlay manager would hedge 100%
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of the underlying US exposure if spot Euro–dollar broke above all three of the 32-, 61- and117-day moving averages. If Euro–dollar was only able to break above two out of the threemoving averages, the currency overlay manager would hedge only one-third of the underlying.In all other cases, they would remain unhedged.As with the differential forward strategy, the trend-following strategy may involve numeroustransactions and thus may cause potential concern for investors with regard to transaction costs.However, such costs have historically been small relative both to the consistent returns thathave been provided by such strategies and also to the potential losses of not hedging. Figure 8.3looks at the dollar–mark exchange rate from 1975 to 2000, showing clearly that there weredefinite and sustained trends, both in the exchange rate and in interest rate differentials whichcould have been – and were – exploited to varying degrees by the differential forward andtrend-following strategies.8.7.3 Optimization of the Carry TradeThe final strategy example that we will look at for active currency managers is that of optimizingthe carry trade. We looked at the carry trade idea initially in Chapter 2 and will do so again inChapter 9 in the context of an appropriate strategy for currency speculators, when using a riskappetite indicator, for the purpose of gauging when are the best and worst times to buy highercarry currencies (and thus go short the lower carry currencies).This combination of a risk appetite indicator and a basket of higher carry currencies canalso be used for the purpose of currency hedging by an active currency manager who tradesand hedges currency risk around their benchmark. For a currency speculator, the principle ofthe risk appetite/carry trade combination is that the basket of higher carry currencies shouldbe bought when the risk appetite indicator is in either risk-seeking or risk-neutral mode andshould be shorted when it is in risk-aversion mode. Similarly, the currency hedger could use thiscombination of indicators to go underweight the hedge relative to the benchmark in higher carrycurrencies when the risk appetite indicator is benign and overweight when the indicator movesinto risk aversion. Such a strategy should reduce transaction costs relative to a passive currencymanagement programme, while also reducing the portfolio’s overall risk and adding alpha.
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Yet, we can fine tune this strategy still further using a portfolio optimizer to take into accountthe volatility and correlation of currencies in addition to their yield differentials alone. Thisshould both in theory and practice produce better returns than the simple carry trade strategy.The carry trade can be an excellent strategy by itself for adding alpha, however it can also exhibitsubstantial volatility at times. A fine example of this was when the dollar–yen exchange ratefell by around 15% in the space of a few days in October 1998. By comparison, the optimizedcarry trade would in the case of the currency speculator represent the buying of higher carrycurrencies with low volatility and the selling of low carry currencies with high volatility. Forthe currency hedger, this would in turn mean going underweight the hedge relative to thebenchmark on higher carry currencies with low volatility and overweight the hedge on lowercarry currencies with higher volatility.For both a portfolio manager who is looking to hedge currency risk and an active currencymanager who can trade that currency risk, optimizing the carry trade can be a useful andproductive way both to reduce risk and to add alpha. Indeed, it is an improvement on thedifferential forward strategy in so much as that is another expression of a basic carry tradestrategy. The optimized carry trade strategy has consistently produced good returns with ofnecessity less volatility, resulting in higher Sharpe and information ratios.It should of course be noted that just as one can optimize the carry trade for improvedperformance over the simple carry trade, so one can do exactly the same thing for eitherthe differential forward strategy or the trend-following strategy. One does this by looking atvolatility-adjusted exposure rather than the simple exposure per se. Thus, for example in thecase of the differential forward strategy, one can over an extended period of time look at therelationship between implied volatility and historical volatility of the underlying exchange rate.Optimizing for volatility-adjusted exposure, the active currency manager would increase theleverage of the forward hedge when implied vol is below a predetermined threshold relative tohistoric vol at the same time as the forward points are in favour of the hedger, and converselylower it when implied vol is above. The extent to which this generally improves performancefar exceeds any concerns about increased transaction costs. One thing that may have to be takeninto account however is the likelihood that raising or lowering the leverage of a differentialforward strategy, both on an absolute basis and relative to the benchmark, may have an impacton the volatility of the tracking error.Similarly, one can seek to optimize through volatility-adjusted exposure the trend-followingstrategy. Again, this should improve on the alpha provided by the basic strategy. A final pointon these active currency strategies is that they are obviously not dependent on the base currencyfor adding alpha given that the total portfolio weighting and risk remains the same whateverthe base currency.
8.8 EMERGING MARKETS AND CURRENCY HEDGINGIt has been noted that emerging markets have different market properties to those of thedeveloped markets. Here, it is important to sell these out and then in turn relate them to theconsiderations of passive and active currency risk management. First off, let us look at themajor differences that appear present in emerging markets:
r Liquidity risk – Emerging market currencies are less liquid than their developed counterparts. For instance, every day some USD300 billion goes through EUR–USD. This compareswith around USD10 billion daily in the South African rand. Needless to say, this lower liquidity affects pricing and price action.
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r Convertibility risk – Even less than liquidity risk, convertibility risk is not a consideration fordeveloped currency markets as all major currencies are freely floating and fully convertible.A number of emerging market currencies however are still not convertible on the capitalaccount, and indeed a few are still not fully convertible on the current account.r Exchange controls – In line with this, several emerging market currencies still have varyingdegrees of exchange rate controls, which also distort exchange rate pricing and economicactivity. Exchange controls create “black market” activity and paradoxically can lead tocapital flight.r Emerging markets have structurally high levels of inflation – Stronger growth levels andeconomic inefficiencies are important reasons behind structurally high levels of inflationrelative to developed markets. This in turn means that policy interest rates are in mostcases substantially higher in emerging markets than in developed markets, resulting in highforward premiums.r Capital inflows however can depress market interest rates – The size of global capitalflows relative to the size of local capital markets in most emerging markets can mean thatthe latter are swamped by a relatively small portfolio shift in assets either into the market orout of it. As a result, interest rate volatility is a lot higher.r Forward rate bias is lower in emerging markets – While forward exchange rates arepoor predictors of future spot exchange rates in the developed markets, this is less so inmany emerging markets. The exhaustive 2000 study by Bansal and Dahlquist tested thepresence of forward rate bias and found emerging market currencies show significantly lesscorrelation between current interest rate differentials and subsequent spot returns than thosein the developed markets. That said, emerging market currencies tend to appreciate on areal basis and then collapse to adjust for the trade balance deterioration caused by that realexchange rate appreciation.r Implied emerging market volatility below developed market volatility is a buy signal –Historically, lower levels of implied volatility in emerging market currencies than thecorresponding developed market currencies has proven a good buy signal for the former.Intuitively, emerging market volatility should be higher, though there are periods when thesheer weight of capital inflows forces it artificially lower. Note that emerging market implied volatility is skewed in that it tends to fall only when the emerging market currency isstrengthening, but always rises when the currency weakens.r Implied emerging market volatility is a very poor predictor of future exchange rates –Looking at previous emerging market crises, the options market has usually got it “wrong”in the sense that such crises have never been priced in ahead of time by the options market.Thus, we can say that the options market is a poor predictor of future exchange rate levelsin the emerging markets, though measured against historic volatility levels it may well be amuch better indicator of relative value.What we find in the emerging markets is that shifts in global capital flows have major domesticinterest rate implications. For instance, high inflation and therefore interest rate differentialsshould, according to classical economic theory, suggest a depreciation of the local currencyin proportion to that interest rate differential or forward premium. However, this may notoccur due to heavy capital inflows, which swamp the domestic market’s ability to cope withthese without economic distortion. As a result of this, the currency may experience significantnominal and real appreciation, in seeming violation of the international Fisher effect andcovered interest rate parity. Real currency appreciation however leads to a real economic shock,and more specifically real trade and current account balance deterioration. Eventually, this has
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to be reversed and not too surprisingly through real currency depreciation. The longer andmore powerful the real appreciation, the more violent the subsequent depreciation. Emergingmarket currencies trade in these types of cycles, in line with the “speculative cycle” that welooked at earlier in the book. As a result, we can tell from this that the forward rate biasis extreme for emerging market currencies on both sides of the forward. In line with this,some caution is needed in using the differential forward strategy in the emerging markets.Emerging market interest rate differentials would mean theoretically that an investor neverhedged emerging market currency risk using the differential forward strategy, yet this is clearlynot the appropriate strategy in some cases.For similar reasons, the carry trade has provided significant alpha for active currency managers, both in the basic and in the optimized version. However, the distortion to interest andexchange rates that capital inflows provide in emerging markets means that a significantlyhigher degree of both care and discretion is needed in picking higher carry currencies to eitherinvest in or hedge depending upon the reading of the risk appetite indicator.
8.9 SUMMARYIn conclusion, when portfolio managers are taking a risk reduction approach, there is a strongincentive to be fully hedged, particularly for fixed income fund managers who generally haveless opposition to such an idea than their equity counterparts. This is consistent with the factthat a significant part of a fixed income portfolio’s risk is the currency risk. On the other hand, ifthe portfolio manager is adopting a performance approach, an active currency risk managementapproach for the purpose of adding alpha is clearly more important.In Chapters 7 and 8, we have looked at the “fundamental” world of corporations on the onehand and “real money” or institutional investors on the other, and how they deal respectivelywith the issue of currency risk. For the most part, their approach to currency risk is that of thehedger. On the other hand, the vast majority of currency market participants are speculators,that is people who trade currencies without an underlying attached asset. While many whofocus on the currency markets put the emphasis on so-called “real” flow, the reality is in factthat this makes up the minority of overall flow relative to speculation. It is to this speculative –and misunderstood – world that we now turn.
REFERENCESFor more on this subject, the following is a brief list of useful references:Acar, E. and Maitra, B. (2000/2001). Optimal portfolio selection and the impact of currency hedging.The Journal of Performance Measurement Winter.Bansal, R. and Dahlquist, M. (2000). The forward premium puzzle: different tales from developed andemerging economies. Journal of International Economics 51.Bilson, J. (1990, 1993). Value, yield and trend: a composite forecasting approach to foreign exchangetrading. In A. Gitlin (ed.), Strategic Currency Investing: Trading and Hedging in the Foreign ExchangeMarket, Probus Publishing.Black, F. (1989). Universal hedging: optimising currency risk and reward in international equity portfolios.Financial Analysts Journal July/August.Choie, K. (1993). Currency exchange rate forecast and interest rate differential. Journal of PortfolioManagement Winter.Fama, E.F. (1984). Forward and spot exchanges. Journal of Monetary Economics 14, 319–338.Froot, K. and Thaler, R. (1990, 1993). Anomalies: foreign exchange. Journal of Economic Perspectives4 (3).
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Kritzman, M. (1989). Serial dependence in currency returns: investment implications. Journal of PortfolioManagement Fall.Kritzman, M. (1993). The optimal currency hedging policy with biased forward rates. Journal of PortfolioManagement Summer.Lequeux, P. and Acar, E. (1998). A dynamic benchmark for managed currency funds. European Journalof Finance 4, 311–330.Levich, R. and Thomas, L. (1993). Internationally diversified bond portfolios: the merits of active currencyrisk management. In A. Gitlin (ed.), Strategic Currency Investing: Trading and Hedging in the ForeignExchange Market, Probus Publishing.Perold, A. and Schulman, E. (1988). The free lunch in currency hedging: implications for investmentpolicy and performance standards. Financial Analysts Journal.Silber, L.W. (1994). Technical trading: when it works and when it doesn’t. The Journal of DerivativesSpring.Strange, B. (1998, updated 2001). Currency matters. European Pension News 28 May (Currency OverlaySupplement), 19–21.Taylor, S.J. (1990). Profitable currency futures trading: a comparison to technical and time-series tradingrules. In L.R. Thomas (ed.), The Currency Hedging Debate, IFR Publishing Ltd.The Frank Russell Company (2000). Capturing alpha through active currency overlay, May.
ADDITIONAL SECTION FOR THE SECOND EDITIONIn Chapter 8, we examined the basics of managing currency risk for an investor, looking atspecific approaches and strategies such as “risk reduction”, “alpha generation”, “passive andactive currency management”, and “relative and total return”. In this additional section weexamine in much more detail a specific investment approach towards managing currency riskthat has become increasingly prevalent within “real money” or “relative return” investmentfunds – currency overlay.
Currency Overlay: History and the BasicsThere is some dispute over when exactly the first currency overlay mandates were awarded,but there is general agreement that it was some time in the mid- to late-1980s. However, itwas not until the early 2000s that currency overlay really came into its own as a separate anddistinct investment approach; those who argue that it happened earlier in the 1990s would havesearched in vain for any specific textbooks on the subject at that time. Even today, the literatureon currency overlay is relatively sparse, written either by currency overlay fund managers or bybank advisers to currency overlay funds. To my knowledge, there is as yet no specific academictextbook on the subject of currency overlay, nor for that matter, any specific university courseon the subject. Arguably, when both of these things happen, it will really have become a specificinvestment approach in its own right.That said, and despite these gaps, the strides made by the currency overlay investmentapproach in the last decade have been very significant. Before we go into this in more detail, itwould probably be prudent to deal first with the basics behind currency overlay. For this purpose,we define currency overlay as the investment approach, which, for the benefit of real money orrelative return investment funds, seeks to manage currency risk separately and distinctly fromthe “underlying exposure” in the fund. Indeed, having read this chapter, this part should be clear.Currency overlay, however, has made this concept into a specific investment style or approach.Readers will no doubt be aware that it has taken some time for many real money funds,particularly those focused on managing equity portfolios, to consider that currency risk should
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be managed at all. Indeed, from 1945 to 1971, the concept of currency risk was all but irrelevantdue to the Bretton Woods arrangement under which the US dollar was pegged to gold and allmajor currencies were in turn pegged to the dollar. However, after 1971–1973, when the BrettonWoods arrangement was abandoned, currency risk became an increasingly important concern.For many years, currency risk was simply thought to be embedded risk within equity exposure.However, as both currency and overall market sophistication grew and, as importantly, as equitymarkets suffered significant falls in the 1970s and 1980s, a source of return diversification wassought. In the mid- to late-1980s, and more importantly in the 1990s, two things were realized:(1) managing currency risk might boost overall returns and (2) currency risk itself might be asource of return diversification. Since then, real money or relative return investment funds haveconsidered various approaches in managing their currency risk. One of the main approachesis currency overlay – that is, by taking on a specialist currency overlay manager to manage thecurrency risk separately from the “underlying” portfolio.Traditionally, the main buyers of currency overlay to manage their currency risk have beenpension funds. Granted, pension funds were initially slow to recognize the need for managingcurrency risk and thereafter for taking on specialist currency risk managers, not least becauseof their inherently conservative nature. However, as the currency overlay industry has grownand the benefits to returns have become increasingly evident, pension funds have becomeincreasingly active in giving mandates to currency overlay funds. The fact that pension fundsremain the main buyers today of currency overlay is in large part a function of importantchanges within the pension fund world itself. Changing demographics as a result of significantmedical advancement have meant two things:
r Pension funds – and fellow travellers such as life insurers – have been undertaking anincreasing portion of overall investment flows.
r Pension funds have needed to access longer-dated assets, which produce higher returns givenincreasing life expectancy.As a result of this, the secular – as opposed to cyclical – trend has been for pension funds toput increasing focus on equities at the expense of fixed income. The process of globalization,which accelerated dramatically after the end of the Cold War, has in turn put increasing focuson international investment. Pension funds have thus, to an increasing extent, sought to managetheir currency risk in order to maximize these more aggressive return targets. There are basicallytwo types of pension fund – defined benefit (DB) and defined contribution (DC). Becauseof the much greater obligations they have to meet, it should be no surprise that DB pensionfunds have been more aggressive investors, both with regard to their “underlay” investmentsinto equities and with regard to adopting currency risk management through currency “overlay”.Currency Overlay: Return DiversificationA key attraction for pension funds – in addition to enhancing the overall returns on their“underlay” – was that currency returns tend to have relatively low correlations with other assetmarkets. Sufficient analysis has been done on this and empirical evidence has been collected toensure that this is a robust conclusion. That said, the correlation between currency and specificasset markets can vary. As noted earlier in the book, currency risk tends historically to makeup around 30% of equity return volatility, whereas it makes up around 60-70% of fixed incomereturn volatility. On the face of it, this would suggest that there is a much greater incentiveto hedge FX risk within a fixed income than an equity portfolio. The fact that currency risk
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makes up only a relative small part of equity return volatility is because equity has historicallybeen a more volatile asset than currency.The initial reaction of real money equity funds was to see this as an excellent reason for notmanaging currency risk. However, the increasing focus on return diversification, particularlyafter the 1987 Crash, changed the way that the equity community viewed currency risk. Admittedly, this process has taken many years. Equity fund managers, who initially thought currencyrisk to be all but irrelevant, generally admitted to a relative lack of knowledge about how tomanage currency risk. The rise of currency overlay in the 1990s provided real money equityfunds with a specialist investment capability of managing their currency risk, reducing overallreturn volatility and at the same time providing a further source of return diversification. Bycontrast, fixed income fund managers have traditionally been much more focused on currencyrisk from the start, given the fact that it makes up a much higher percentage of overall returnvolatility. Because of this, fixed income fund managers have, of necessity, been more skilledat managing currency risk. Ironically, this has in the short run meant a reduced need of fixedincome funds to take on currency overlay managers. Indeed, it is for these very reasons thatthe vast majority of currency overlay mandates in the last 20 years have been by real moneyequity funds – and specifically by DB pension funds.To date, the vast majority of pension fund – whether DB or DC – assets have been foundin the G10 countries, notably the US, the UK and Japan. As a result, it should be no surprisethat these countries, together with the likes of Australia and Switzerland, are where the vastmajority of currency overlay mandates have been awarded. Nevertheless, currency overlayremains relatively underdeveloped compared to other investment approaches. Only around10% of pension fund assets have currency overlay mandates – and this only focuses on the“major” or developed countries. With Asia – home to trillions of dollars of savings – openingup its markets, the potential for currency overlay would seem to be explosive.Currency Overlay: Key IssuesThe aim of currency overlay is to produce a stream of returns that provides diversificationby being negatively correlated to the “underlay”, with the aim of reducing overall portfoliovolatility while enhancing returns. Typically, currency overlay managers use currency forwardcontracts for this purpose, though a small but increasing number use currency options. Whateverthe case, the maturity of these contracts must match that of the benchmark otherwise trackingerror is effectively created – and, moreover, for no expected return. The vast majority ofpublished hedged benchmarks use 1-month contracts.When a currency overlay mandate is being considered, there are essentially four key issuesthat the “underlay” manager and the currency overlay manager should consider. These are:
r The benchmark that will be usedr The tracking error constraintsr The benchmark hedging ratior The “underlay” itselfThe BenchmarkThe type of currency hedging benchmark used by a fund depends almost entirely on the riskappetite of the “underlay” fund manager. Popular underlying benchmarks for international
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equity funds include the MSCI and FTSE indices. Hedging of such benchmarks is typicallyachieved by buying or selling currency 1-month forward – or via options – and rolling asappropriate. The hedge is of course based on the value of the equ