<s> Currency OverlayNeil Record
Currency Overlay
Wiley Finance SeriesCurrency OverlayNeil RecordActive Investment ManagementCharles JacksonOption TheoryPeter JamesThe Simple Rules of Risk: Revisiting the Art of Risk ManagementErik BanksCapital Asset Investment: Strategy, Tactics and ToolsAnthony F. HerbstBrand AssetsTony TollingtonSwaps and other DerivativesRichard FlavellCurrency Strategy: A Practitioner’s Guide to Currency Trading, Hedging and ForecastingCallum HendersonThe Investor’s Guide to Economic FundamentalsJohn CalverleyMeasuring Market RiskKevin DowdAn Introduction to Market Risk ManagementKevin DowdBehavioural FinanceJames MontierAsset Management: Equities DemystiﬁedShanta AcharyaAn Introduction to Capital Markets: Products, Strategies, ParticipantsAndrew M. ChisholmHedge Funds: Myths and LimitsFrancois-Serge LhabitantThe Manager’s Concise Guide to RiskJihad S. NaderSecurities Operations: A guide to trade and position managementMichael SimmonsModeling, Measuring and Hedging Operational RiskMarcelo CruzMonte Carlo Methods in FinancePeter JäckelBuilding and Using Dynamic Interest Rate ModelsKen Kortanek and Vladimir MedvedevStructured Equity Derivatives: The Deﬁnitive Guide to Exotic Options and Structured NotesHarry KatAdvanced Modelling in Finance Using Excel and VBAMary Jackson and Mike StauntonOperational Risk: Measurement and ModellingJack KingAdvanced Credit Risk Analysis: Financial Approaches and Mathematical Models to Assess, Price and Manage Credit RiskDidier Cossin and Hugues PirotteInterest Rate ModellingJessica James and Nick WebberVolatility and Correlation in the Pricing of Equity, FX and Interest-Rate OptionsRiccardo RebonatoRisk Management and Analysis vol. 1: Measuring and Modelling Financial RiskCarol Alexander (ed.)Risk Management and Analysis vol. 2: New Markets and ProductsCarol Alexander (ed.)Interest-Rate Option Models: Understanding, Analysing and Using Models for Exotic Interest-Rate Options (second edition)Riccardo Rebonato
Currency OverlayNeil Record
C 2003Copyright 
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Library of Congress Cataloging-in-Publication DataRecord, Neil.Currency overlay / Neil Record.p.cm.Includes bibliographical references and index.ISBN 0-470-85027-2 (Cloth: alk. paper)1. Currency overlay. I. Title.HG4529.5 .R43 20032003014721332.4 5—dc22British Library Cataloguing in Publication DataA catalogue record for this book is available from the British LibraryISBN 0-470-85027-2Typeset in 10/12pt Times by TechBooks, New Delhi, IndiaPrinted and bound in Great Britain by Antony Rowe Ltd, Chippenham, WiltshireThis book is printed on acid-free paper responsibly manufactured from sustainable forestryin which at least two trees are planted for each one used for paper production.
To Julie, Chris, Rob, Helen, Katy and Guy – a cure for insomnia!
ContentsList of boxes
xv
Biography
xvii
Acknowledgements
xix
1 Introduction1.1 Investment background1.1.1 Investor instruments1.1.2 Key investor categories1.1.3 Deﬁned beneﬁt pensions1.1.4 Deﬁned contribution pensions1.1.5 Investors in a currency overlay context
1223566
2 The Problem2.1 Asset and liability valuations, volatility and solvency2.1.1 Funded pension schemes2.1.2 Asset valuations2.1.3 Liability valuations2.1.4 Liabilities’ discount rate2.1.5 FRS172.1.6 IAS192.1.7 Summary on assets and liabilities2.2 History of pension fund cross-border portfolio investing2.2.1 US2.2.2 UK2.3 Currency volatility2.4 Corporate parallels in cross-border investing2.4.1 Foreign assets2.4.2 Foreign debt2.4.3 Economic impact of corporate currency exposure
999911111313131414141520202021
viii
Contents
3 Currency Hedging3.1 Instruments available3.1.1 Foreign debt3.1.2 Forward contracts3.1.3 Currency swaps3.1.4 Currency futures3.1.5 Currency options3.2 Option pricing3.2.1 First principles3.2.2 Option pricing theory3.3 The Black–Scholes model3.3.1 Market assumptions3.3.2 The model3.3.3 Understanding option pricing3.3.4 The role of assumptions in option pricing3.3.5 Practical implications of assumptions violations3.4 Currency option pricing history3.4.1 Lognormality3.4.2 Monte Carlo models3.4.3 Costs3.4.4 Sensitivity3.5 Interest rates and forward currency rates3.6 Currency Surprise3.6.1 What is currency surprise?3.6.2 Currency surprise calculation3.6.3 Why not spot returns?3.6.4 Geometric linking and ‘adding across’
232323253134373839394040414246484949505051515353535457
4 Foreign Exchange Market – History and Structure4.1 A brief history of the foreign exchange market and how instrumentsdeveloped4.1.1 Bretton Woods4.1.2 Central banks as buffer4.1.3 Ad hoc foreign exchange market development4.1.4 Free markets dominate4.1.5 The euro4.1.6 Instruments4.2 Basic structure4.2.1 Market size4.2.2 Banks – the market-makers4.2.3 Customers4.2.4 Clearing mechanism4.2.5 Turnover excluding ‘clearing’4.3 Customer types4.3.1 Industrial and commercial companies (ICCs)4.3.2 Oil and commodity dealers and merchants4.3.3 Financial institutions (banks and insurance companies)4.3.4 FX option writers
61616161626364656566676769707070717172
Contents
4.3.5 Investment pool traders in FX (hedge funds, proprietarytraders)4.3.6 Investment managers and currency overlay managers4.3.7 Central banks4.4 Physical and regulatory issues4.4.1 Exchange controls4.4.2 Taxation4.4.3 Financial regulation
ix
72737475757980
5 Theory of Currency Hedging of International Portfolios5.1 Lognormal random walk returns5.1.1 Measurement5.1.2 Returns5.1.3 Volatility5.1.4 Normally distributed period returns5.1.5 A simple test5.1.6 Relevance to currency hedging5.2 The ‘free lunch’5.2.1 Which way up?5.2.2 Adding ‘moving parts’5.2.3 Currency exposure is different5.2.4 Correlation of asset classes5.3 Hedging and the efﬁcient frontier5.3.1 Constructing an optimiser including currency5.3.2 Optimiser methodology5.4 Implications of transactions costs5.4.1 Expected portfolio added value from passive hedging
83838384868889899091919394979798101102
6 Passive Currency Overlay6.1 Mechanics6.1.1 Original maturity of forward contracts6.1.2 Frequency of cash ﬂows6.1.3 Currencies to be hedged6.1.4 Benchmark or actual asset weights to be hedged?6.1.5 Denominator of ‘contribution from hedging’6.1.6 Frequency of asset valuation6.2 Rebalancing6.2.1 Frequency of rebalancing6.2.2 Rebalancing buffer (Y/N? size)6.2.3 Buffer – ‘percentage of what?’6.2.4 Delay in rebalancing6.2.5 Valuation rates6.3 Cash ﬂow6.4 Costs6.4.1 Direct costs6.4.2 Indirect costs6.4.3 Summary on costs6.5 Postscript on costs – conﬂict of interest
105105105106106108110110111112114115115116116117118119121122
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Contents
7 Currency Overlay Benchmarks7.1 What is a currency benchmark?7.1.1 Misleading currency attribution7.1.2 Benchmark as portfolio7.1.3 Benchmark mechanics7.2 Investability7.2.1 Forward currency prices7.2.2 WM/Reuters rates7.2.3 Contract rolling7.2.4 Scale of contracts7.2.5 Rebalancing7.2.6 Geometric linking7.3 Design7.3.1 Asset plus currency overlay methodology7.3.2 Special case – monthly benchmark calculation7.3.3 Valuation of unmatured contracts7.3.4 Benchmark hedge ratio7.3.5 Embedded currency plus currency overlay methodology7.3.6 Currency overlay only methodology7.3.7 Other methodologies7.3.8 A currency benchmark with or without asset returns?7.3.9 Pricing/costs7.3.10 Prices, not interest rates7.3.11 Rebalancing7.3.12 Original contract maturity7.3.13 Constant maturity benchmarks7.3.14 Discounting7.3.15 Benchmark hedge ratio – strategic considerations7.3.16 Currency coverage and denominator calculation7.3.17 Underlay7.3.18 Benchmark performance7.3.19 Benchmark cash ﬂows7.4 Current practice7.5 Worked examples7.5.1 Asset plus currency overlay methodology7.5.2 Embedded currency plus currency overlay methodology7.5.3 Currency overlay only7.6 Tracking error7.6.1 Passive hedging7.6.2 Summary on tracking error
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8 Overlaying Different Asset Classes8.1 Equities8.1.1 Correlation – the historical evidence8.1.2 Correlation evidence8.1.3 Individual currency: equity correlations8.1.4 Stability of correlations
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8.1.5 Summary on correlation8.1.6 Embedded currency8.1.7 Firm level analysis8.1.8 Country index equity returns8.1.9 International equity correlations8.1.10 Volatility reduction – the historical evidence8.1.11 Effect of hedging on portfolio risk8.1.12 Base-currency-speciﬁc graphsHedge ratios8.2.1 Current debateBonds8.3.1 Correlation8.3.2 Stability of correlations8.3.3 Volatility reduction from hedging bonds – the historicalevidence8.3.4 International diversiﬁcationPropertyOther classes
162162162167169170172174177177182182185
9 Is the Currency Market Efﬁcient?9.1 Types of inefﬁciency9.2 Making the case for currency market inefﬁciency9.2.1 Cyclical behaviour9.2.2 Lack of statistical arbitrage9.3 Empirical evidence for medium-term trends9.4 Forward rate bias – another inefﬁciency9.4.1 What is the evidence for the FRB?9.4.2 Risk premium9.4.3 Monetary policy and inﬂation9.4.4 Nominal rate illusion9.4.5 Other inefﬁciencies9.5 A successful universe?9.5.1 An example of different perspectives in the FX market9.6 Summary on evidence for inefﬁciency9.6.1 Weak form efﬁciency9.6.2 Semi-strong form efﬁciency9.6.3 Strong form efﬁciency9.6.4 Transactional efﬁciency
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10 Active Currency Overlay – Management Styles10.1 The problem10.2 Modelling and forecasting10.2.1 Modelling – Occam’s razor10.2.2 Can models work?10.2.3 What about active management without models?10.2.4 Dealing and practical execution10.2.5 Timeliness of inputs
205205206206207209210210
8.28.3
8.48.5
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10.2.6 Judgement and modelling10.2.7 Deal execution10.3 Active management styles10.3.1 Fundamental10.3.2 Technical10.3.3 Option-based10.3.4 Dynamic
211212212213219229234
11 Active Currency Overlay – Evidence of Performance11.1 Surveys11.1.1 Currency overlay performance surveys11.1.2 Performance summary11.2 Who loses?
239239239240240
12 Implementing Currency Overlay12.1 Summary check-list12.1.1 What mandate type?12.1.2 For risk-reducing overlay – benchmark hedge ratio12.1.3 Investment guidelines – active12.1.4 Investment guidelines – passive12.1.5 Investment guidelines – alpha12.1.6 Bank FX lines12.1.7 Bank contract conﬁrmation12.1.8 Investment management agreement12.1.9 Reporting requirements12.1.10 Periodic cash and contract reconciliation12.1.11 Bank contract settlement procedures12.1.12 Benchmark calculation12.1.13 Performance measurement12.1.14 Summary check-list12.2 Practical questions and answers
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13 Looking Ahead13.1 Development of active management styles13.1.1 Top-down/bottom-up13.1.2 Growth/value13.1.3 Contrarian/momentum13.1.4 Ethical13.1.5 Hedge fund styles13.1.6 Summary on styles13.2 Natural selection of overlay managers13.2.1 Conﬂict of interest13.3 Extending the range of hedging instruments13.4 Will inefﬁciencies grow or shrink?13.4.1 Can outperformance by currency overlay managers continue?
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Contents
xiii
References/Useful Reading
261
AppendicesAppendix 1 – Boundary conditions for forward arbitrageAppendix 2 – Lognormal returnsAppendix 3 – AIMRR reportAppendix 4 – Sample investment guidelines
263263267277285
Index
289
List of Boxes1.1 What is currency overlay?1.2 Life expectancy1.3 Deﬁned beneﬁt pensions
245
2.12.22.32.42.52.6
DiscountingCurrency surpriseSwift codesVolatilityThe euroSwaps
121618202122
3.13.23.33.43.53.63.73.8
Forward currency contractsFX swapsBid/offer spreadsFuturesCurrency optionsNormal and lognormalForward currency ratesLocal currency returns
2526293438415256
4.14.24.34.44.54.64.7
Capital ﬂowsCurrency unionsNettingMarket-makersCLS BankExchange controlsExchange controls – UK case study
62646768697779
5.15.25.35.4
ConvexityCentral Limit TheoremSiegel’s paradoxFat tails
84858788
xvi
List of Boxes
5.5 Mean-variance optimisation5.6 Modern portfolio theory
9799
6.1 Tracking error6.2 Tradeable currency6.3 Proxy hedge
107108109
7.1 Benchmarks7.2 MSCI EAFE
125144
8.1 Embedded currency exposure8.2 Duration
163190
9.1 Trends9.2 Forward rate bias9.3 Currency risk premium
197198200
10.110.210.310.410.510.610.710.810.9
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Cross hedgingAlpha‘Star’ investorsActive currency stylesCapital accountPurchasing power parityMean reversionInformation ratioSimulations
BiographyNeil Record was educated at Balliol College, Oxford, where he studied Philosophy & Psychology; Essex University and University College, London, from where he gained an MScin Economics with Distinction. His ﬁrst job, in 1977, was as an Economist in the EconomicIntelligence Department of the Bank of England. While there he had his ﬁrst taste of largescale economic modelling, and his ﬁrst exposure to an exchange rate forecasting model. It wasnotable then that the exchange-rate forecasting model was one of the weaker elements of theBank’s model of the UK economy.In 1979, Neil moved to work as a commodity price forecaster at the chocolate maker Marsin Slough, UK. He quickly moved into line responsibility for buying commodities, and then tobuying forward currency for the company’s commodity and import needs. While at Mars hedeveloped an innovative process for controlling currency risk and exploiting currency marketinefﬁciency.In 1983, aged 29, Neil left Mars to establish his own specialist currency managementbusiness, Record Treasury Management (renamed Record Currency Management in 2001).Record Currency Management was a pioneer of currency overlay for pension and investmentfunds, and in April 1985 it was awarded the worldwide ﬁrst-ever institutional currency overlaymandate – from the UK Water Authorities’ Superannuation Fund.Today, 20 years after founding Record Currency Management, Neil remains Chairman andCEO. He divides his time between client liaison, currency overlay design work, and speakingand writing about currency overlay. His other interests include a non-Executive Directorshipof RDF Media – a leading UK independent TV production company – opera, baroque music,tennis, skiing, travel, art, architecture and watching his childrens’ sporting activities. He isdivorced and lives with his partner, Julie, and his three children and her two children.
AcknowledgementsI am indebted to my colleagues at Record Currency Management, particularly Peter Wakeﬁeld,Leslie Hill, Bob Noyen, Mike Timmins, Ian Harrison, Joel Sleigh, Dave Murphy, SimonWilliamson, James Dyas, Sebastian Jans and Dmitri Tikhonov for their technical input, adviceand debate. I am also grateful to Chris Jackson, Jane Deane and Julia Edbrooke for theiradministrative support. I am also indebted to Brian St.J. Hall of Hewitt Bacon & Woodrow foradvice and comments on earlier drafts. Finally, I must thank Julie for putting a glass of winein my hand after particularly heavy days!
1IntroductionCurrency overlay is a new branch of investment management. Not surprisingly, the literatureis equally new; in particular, there does not exist at the time of writing (2003) any comparablecomprehensive book on currency overlay.Because currency overlay is new, I have chosen to write this book in such a way that it fulﬁlstwo functions: the ﬁrst as a primer; the second as a reference book. Writing for a heterogeneousaudience is difﬁcult at the best of times; writing for a heterogeneous audience and to fulﬁl twofunctions is doubly challenging. I have chosen to enlist a number of techniques to help in thiseffort.
r Argument from ﬁrst principlesWhere possible, I try to limit the reference to external theories or academic literature. Intheory, I would like the able and mathematically literate reader to be able to grasp thearguments in this book without having prior knowledge of the currency world or any of theliterature that surrounds it.r Use of mathematicsI will use only sufﬁcient mathematics to explain my point or make my case. I have avoidedadvanced maths where at all possible. Generally, the only references to ‘given’ mathematicaltheories are in statistical formulae, where there is simply not enough space to derive themfrom ﬁrst principles.r BoxesI will use a technique used by Norman Davies in Europe – a History,1 in which he creates‘boxes’ with self-contained ‘stories’. While a full description of currency overlay is clearlynowhere near as multi-stranded as the history of Europe, nevertheless I believe the readerwill ﬁnd it helpful to have text which is not fully ‘linear’. I also use boxes to explain ordescribe vocabulary which may be unfamiliar.This book is aimed at a wide audience. I anticipate that it will include readers from currencyoverlay managers, from the wider investment management industry, from investment consultants and actuaries, from the more investment-literate pension fund managers, from theinvestment management desks of insurance companies, from foreign exchange dealing banksand from custodian banks. It will inevitably also appear on the desks of students in ﬁnance andrelated disciplines, although it is not written as a textbook.What distinguishes this book from a similar one written as a textbook? Firstly, it is notdesigned to ﬁt in with any class, course, degree or qualiﬁcation. Secondly, it is not designedto be fully rigorous. This is deliberate – full rigour would signiﬁcantly expand the size ofthe book without adding to the core content. Thirdly, a textbook would not typically aim at aheterogeneous audience. A readership of, say, graduates following an AIMR2 qualiﬁcation or a1
Davies, N., Europe – a History, Oxford University Press, December 1996; ISBN 0-195-20912-5.Association for Investment Management & Research – the highly respected American asset management trade association andthe awarder of the CFA qualiﬁcation.2
2
Currency Overlay
postgraduate degree course would expect a great deal less introductory ﬁnance and economics,and a great deal more mathematical rigour.Currency overlay is not, to my knowledge, part of the syllabus of any investment managementor other ﬁnance course at the moment. When, and if, it becomes part of standard graduate orprofessional courses, a textbook will undoubtedly emerge.
1.1 INVESTMENT BACKGROUNDReaders completely unfamiliar with investment may like a brief primer as to the key investmentinstruments and the key investor categories. I do this because I will be referring to theseinstruments throughout the book. The reader familiar with basic investment principles mightlike to skip this short section, and turn to p. 14.1.1.1 Investor instrumentsThere are two main investment classes: equities and bonds, and both of these are also instruments. There is a larger range of smaller asset classes (cash, property, private equity, hedgefunds, commodities), although some of these (e.g. hedge funds) are not instruments.Box 1.1
What is currency overlay?
An investor – say a US investor – decides to invest in the UK stock market. The decisionto invest in the UK is not determined by the investor’s view on the prospects for the UKpound, but by the good prospects for the UK stock market and a desire for diversiﬁcation.However, to buy the UK stocks, the US investor has to buy pounds with dollars on theforeign exchange market. He then buys the UK stocks with the pounds. Each month, theinvestor will get a valuation of this investment, and two markets (not one) will affect thisvaluation – (i) the general level of UK stocks in pounds and (ii) the level of the poundagainst the dollar.The investor may decide that the uncertainty brought about by the variation in the dollar/pound exchange rate is undesirable, and choose to get rid of (or ‘hedge’) it. He hiresa currency overlay manager, whose remit is to maintain a portfolio of forward currencycontracts to offset any movements in the dollar/pound exchange rate. Broadly speaking,these contracts commit the investor to sell ﬁxed amounts of pounds against the dollar atﬁxed dates in the future. This ‘overlay’ does not require any investment on the part of theinvestor; only a credit line with foreign exchange banks to enable the overlay manager tohave the ability to deal in forward contracts with the banks on behalf of the investor.The ‘returns’ of currency overlay come in two ways: forward currency contract valuations and cash settlements on maturing forward contracts. These two combine to becomethe contribution to return of currency overlay. The overlay manager who maintains thecurrency hedge over a constant proportion of the portfolio is conducting ‘passive overlay’;the manager who varies it according to his view on the prospects for the pound is running‘active overlay’.The expression ‘currency overlay’ has been extended recently to cover active mandateswhich are purely return-seeking, rather than risk-reducing. These mandates are not restrictedpurely to forward contracts to sell currencies already owned in the portfolio against the basecurrency – they can utilise any currency pair in either direction.
Introduction
3
Equities (or shares) are a share in a limited liability company, and entitle the holder to theresidual value on winding up of a company, and to regular payments in the form of dividends ofsurplus proﬁts after other claims on the business have been discharged. Quoted equities (thosethat trade on recognised exchanges) are generally sufﬁciently liquid to maintain a ‘secondhand’ price in the market. This market price is the key for much of the later discussion inthis book about international equities and currency risk. For the time being it is worth notingthat the currency in which equities are quoted (which is generally, but not exclusively, thesame as the currency in which the company reports its accounts) is important for the initialcategorisation of equities’ currency risk.Bonds are on the face of it much simpler instruments than equities. They are a loan fromthe investor to a company or other economic entity. Bond-issuing entities include companies, asset-holding special purpose vehicles, governments, international organisations andmixed public/private sector groups. The bond (and I ﬁnd it easiest even in this electronicworld to think of it as a piece of paper) represents a promise of a series of payments bythe issuer to the holder. These payments are a ﬁxed amount of cash (the coupon), say $6per year, until a particular date, and then a payment of principal, which is almost alwaysby convention $100 (or £100 or Eur100 depending on the currency of the bond). Bondcoupon payments are usually made either annually (mainly governments) or semi-annually.For annual payments, the last payment date (when the principal is repaid) is also usually thepayment date of the coupon. There are a huge range of variations on this simple theme –most importantly that there are bonds where both the coupon and the principal are linked toan index of consumer or retail prices (‘index-linked’ bonds), and where the amount of thecoupon varies according to prevailing short-term rates, rather than being ﬁxed (‘ﬂoating rate’bonds).Bonds can be and are issued in a variety of currencies, although they are for practicalpurposes traded (in the second-hand market) in the same currency as their issue currency.1.1.2 Key investor categoriesWho are the main investors in equities and bonds? The ultimate answer is ‘individuals’, butmost of this ownership is diffused through one or more intermediary layers, so that the majorityof the inﬂuential decision-making is made by the managers of large pools of assets. These arecommonly called ‘institutional investors’, although this is something of a misnomer, sincethey are mainly professional commercially-orientated managers, rather than representatives of‘institution