s specific exposures. It is important to stress that models such as PurchasingPower Parity (PPP) or Real Effective Exchange Rate (REER) are not necessarily useful forhedging short-term transaction risk, but they may be very useful in terms of strategic hedging –either for the purpose of longer-term transaction or translation risk hedging.Such “fair value” exchange rate models such as PPP and REER generally assume lack ofprice or trade controls, or other distortions such as abnormally high inflation rates. Some or allof these may not be the case in specific Emerging Market countries. Here too, care is neededwith regards to picking the right currency valuation models for the right countries concernedand resulting exposures. In conclusion, currency valuation estimates from such models as PPPand REER can give an idea of where the currency will snap back to, but not when. Therefore,options are probably more appropriate for strategic hedges than forwards. A reliable currencyvaluation model can help significantly in terms of timing strategic hedges.Hedging Using a Risk Appetite IndicatorIn the previous section, we looked at using a currency valuation model for the purpose ofstrategic hedges. Clearly, while these are useful in terms of longer-dated strategic hedges, theycannot provide much use for short-term transaction exposure. For that purpose, we need a toolthat provides a better and more accurate indication of likely shorter-term moves.In this case, it may be useful for corporate treasury to consider using a risk appetite indicatorsuch as that we looked at in Chapter 2. Spot, forward and option levels are to a significantdegree a function of investor risk appetite. Consequently, when risk appetite is high – that is,
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when investors are seen as being in “risk seeking” mode – spot rates tend to be strong andoption market indicators tend to be depressed. Typically, this is the best time to hedge, althoughit can also be the time when corporate treasury is most reluctant to hedge. For risk dependentcurrencies such as those with current account deficits, and those in Emerging Market countries,the best time to hedge these exposures is generally when the risk appetite indicator is in riskseeking mode. However, corporations should note within this that currencies can potentiallystay in risk-seeking mode for quite some time. As with currency valuation models, risk appetitemodels give a framework for hedging risk, but not necessarily the exact timing. Yet, withinthis, it may still be possible to improve one’s timing using such a tool. When a currency hasbeen in risk-seeking mode for some time and then moves back into risk neutral, this wouldappear to be a good signal for hedging back to the base currency. Similarly, when a currencyhas been in risk aversion for some time, but moves back into risk neutral, this would appear tobe a good signal for reducing or removing the hedge. Corporations should do scenario analysison the specific exposures they have in order to decide on potential hedging triggers using arisk appetite model and, where appropriate, decide ideal hedge ratios for each risk segment –risk seeking, risk neutral and risk aversion.Finally, the last point to make in this chapter is that corporations need to reappraise thekey strategies and assumptions that go into their overall FX hedging policy on a regular basis,lest these become outdated. The first step in this process should be to examine how FX risksarise in their business and in turn how those risks are hedged, both on an absolute basis andrelative to the latest hedge accounting regulations. Secondly, at a more specific level, there aremany tools out there – such as currency valuation, risk appetite and VaR models. Corporatetreasury needs to be aware of these tools and how they might help in the overall hedgingpolicy. Ultimately, both the decision to hedge and the means of doing so are a trade-off. Somewell-known corporations have decided not to go down that road and simply do not hedge FXrisk at all, preferring to focus on their “core” business. From my perspective, the focus withinthat trade-off should always be on managing and reducing risk to minimize earnings volatility.
8Managing Currency Risk II – TheInvestor: Currency Exposure within theInvestment DecisionInvestors and corporations face similar types of risk on foreign currency exposure. For instance,investors face transaction risk when they invest abroad. They also face translation risk on assetsand liabilities if they spread their operations overseas. For its part, the corporate sector clearlyseems to have moved to a view that currency risk is an unavoidable issue that has to bemanaged independently from the underlying business. Within the investor world, the battlefor hearts and minds on this issue is ongoing. There remain specific types of investor who areideologically opposed to the idea of managing currency risk. However, here too, there are signsof a gradual shift towards the view that currencies are an asset class in their own right andtherefore currency risk should be managed separately and independently from the underlyingassets, as the continuing rise in the number of currency overlay mandates would appear toconfirm.
8.1 INVESTORS AND CURRENCY RISKThe relationship between institutional investors and the idea of currency risk has been an uneasyone. For a start, there remain an overly large number of investors who are either unwilling orunable, due to the specific regulations of their fund, to consider currency risk as separate andindependent from the underlying risk of their investment. Such a view is particularly prevalentamong equity, although it is also present to a smaller extent with fixed income fund managers.The aim of this chapter is to err on the practical, to take the ideological out of the equation andseek to demonstrate empirically and theoretically that managing currency risk can consistentlyboost a portfolio’s return.On the face of it, this chapter may seem targeted at only those who manage currency riskon an active basis. This is not the case. Rather, it is aimed at any institutional investor whofaces in the course of their “underlying business” exposure to a foreign currency, whether ornot they are in fact allowed to carry out some of the ideas and strategies presented herein. Letus start then with two core principles on the issue of currency risk:1. Investing in a country is not the same as investing in that country’s currency.2. Currency is not the same as cash; the incentive for currency investment is primarily capitalgain rather than income.Almost before we have started, some may view the above as controversial. In my career, I havecome up against not infrequent opposition to these principles, albeit for varying reasons. Theanswer I have given back has always been the same:The dynamics that drive a currency are not the same as those that drive asset markets
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8.2 CURRENCY MARKETS ARE DIFFERENTThroughout this book, we have looked, albeit from varying perspectives, at the governingdynamics that drive the global currency markets. If we have learned one thing, it is surely this,that the currency markets are by their nature predominantly “speculative”. That is to say, themajority of currency market participants are what we would define as “speculators”, using thedefinition of this book for currency speculation as the trading or investing in currencies withoutany underlying, attached asset. The predominance of speculation within currency markets isneither a good nor a bad thing. On the one hand, it provides needed liquidity for those aspectsof the economy deemed productive rather than speculative. On the other hand, it can andfrequently does lead to overshooting relative to perceived economic fundamentals.The speculative nature of the currency markets may be an important reason why most longterm fundamental equilibrium models work poorly in trying to forecast exchange rates. At theleast, it serves as an excellent excuse for those who otherwise are unable to forecast exchangerates using the traditional methods. All of this may be true, and all of it makes for a verydifferent world from those of the equity or fixed income, markets. By necessity, these are notspeculative by nature since they are themselves underlying assets relating to the economy insome way. This is not at all to suggest that speculation does not occur in equities or fixedincome, for any such suggestion would clearly be foolish. The recent bubble in the NASDAQshould serve as an excellent warning for any who think these markets are always fundamentallydriven and incapable of speculative excess. That said, this same example is surely notable byits rarity. Throughout history, there have indeed been examples of speculative excess across allmarkets. In equity and fixed income markets, relative to “normal” conditions however, these arethe exception rather than the rule. This is not the case in currency markets, where traditionaleconomic theory has all but given up trying to explain short-term moves and longer-termexchange rate models have far from perfect results.The dynamics of the asset and currency markets are “fundamentally” different. Thereforethese risks should be dealt with separately and independently from one another. For the international equity fund manager, investing in a country is not the same and should not be the samedecision as investing in a country’s currency. Eventually, they may have the same risk profileover a long period of time. However it is questionable whether the investor’s tracking errorand Sharpe ratio, not to say the investor themselves, should have to go through that degree ofstress!Equally, currency is not the same as cash. An individual investor may treat currency as cashfrom a relative performance perspective. Unfortunately, however, such a comparison provides afalse picture. Most currency market participants, and therefore the currency market as a whole,do not buy or sell currencies for the income that a “cash” description would of necessity entail.On the contrary, they do so for anticipated directional or capital gain. In other words, they areseeking to profit from precisely the risk that the investor is not hedging! It is a generalization,but nevertheless true that the reluctance to manage currency risk is far more predominantamong equity fund managers than fixed income fund managers. That may have something todo with the intended tenor of the investment, suggesting fixed income fund managers may bemore short-term in investment strategy than their equity counterparts. Any such view seemsgreatly over simplistic, and would require a study on its own to verify or otherwise. Manycannot manage currency risk simply because the rules of their fund do not allow them so to do.There remains however a substantial community of institutional investors who apparently haveyet to be convinced by either the merits or the need to manage currency risk separately. By
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the end of this chapter, it is my hope that I will have caused many within this community to atleast reconsider their view as regards currency risk. To summarize this part, the way currenciesand underlying assets are analysed and the way they trade are both different from each other.Consequently, the way they should be managed should also be different.
8.3 TO HEDGE OR NOT TO HEDGE – THAT IS THE QUESTION!Central to the idea of managing currency risk separately and independently from the riskrepresented by the underlying asset is the issue of whether or not to hedge that currency risk.Just as the idea of separating currency risk continues to attract much debate, so the more specificissue of hedging out that currency risk remains a topic of much controversy and discussion, bothwithin the academic world and within the financial markets themselves. Indeed, while theremay be some who take a pragmatic view of compromise, approaching this from the perspectiveof a case-by-case basis, the majority seem polarized between two opposite and opposing camps.Within the academic world, this is expressed at opposite ends of the spectrum by Perold andSchulman (1988) and by Froot and Thaler (1990, 1993), who advocated on the one hand fullhedging of currency risk and on the other leaving currency risk unhedged.There is a clear division of opinion within the financial markets as well, if perhaps marginallyless pronounced and polarized. Within the institutional investor community, international equity funds are generally known for taking a view of either not hedging currency risk or adoptingan unhedged currency benchmark. Fixed income funds are clearly more tolerant of the idea ofhedging currency risk, frequently adopting a currency hedging benchmark that reflects such aview. We will go through the range of possible currency hedging benchmarks shortly, but fornow suffice to say that they vary at the most basic level, being hedged (partially or fully) andunhedged. The “sell side”, which is used to selling foreign exchange-type products, is wellversed in the need for hedging availability. Conversely, the fixed income sell side within thefinancial industry in general appears to focus more on selling the core product rather than onits denomination, or the potential need to separate and hedge out that corresponding currencyrisk.In response, the majority of rigorous studies have distilled this debate down to an elegantcompromise between risk and reward, focusing less on an absolute answer to the questionthan the need to account for the individual investor’s requirements and the portfolio varianceacross the spectrum of hedging strategies. The debate between hedging or not hedging thusremains unresolved, and there appears little prospect on the horizon of that changing. Thereis no one answer to the question of whether or not to hedge currency risk, nor perhaps shouldthere be. Any such answer depends crucially on the specifics of the investor’s portfolio aimsand constraints. The assumption might on the face of it be that one’s approach to managingcurrency risk can be broken down simply into active or passive – or alternatively not to managecurrency risk! At a slightly more sophisticated level however, the focus should be on the typeof returns targeted; that is absolute vs. relative returns.
8.4 ABSOLUTE RETURNS – RISK REDUCTIONJust as a corporation has to decide whether to run their Treasury operation as a profit or as a riskreduction centre, so a portfolio manager has to make the same kind of choice. While one cantheoretically change one’s core approach to managing the portfolio at any time, it is usually
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better to make that choice right at the start. In the process, the portfolio manager should decidewhat style of portfolio management is to be adopted as regards the underlying investments,the desired return profile of the portfolio and also the style of currency management to beused. In the case of a portfolio manager who is focusing on absolute returns, the currency riskmanagement style that is synonymous with this focuses on reducing the risk of the overallportfolio. This in turn usually means adopting a passive style of currency risk management.8.4.1 Passive Currency ManagementPassive currency hedging or currency management involves the creation of a currency hedgingbenchmark and sticking to that benchmark come what may, avoiding any slippage. As a result,it involves the taking of standard currency hedges and then continuing to roll those for the lifeof the investment. The two obvious ways of establishing a passive hedging strategy are forinstance:
r Three-month forward (rolled continuously)r Three-month at-the-money forward call (rolled continuously)The advantage of passive currency management is that it reduces or eliminates the currencyrisk (depending on whether the benchmark is fully or partially hedged). The disadvantage isthat it does not incorporate any flexibility and therefore cannot respond to changes in marketdynamics and conditions. Passive currency management can be done either by the portfoliomanager themselves or by a currency overlay manager, and focuses on reducing the overallrisk profile of the portfolio.8.4.2 Risk ReductionThe emphasis on risk reduction within a passive currency management style deals with thebasic idea that the portfolio’s return in the base currency is equal to:The return of foreign assets invested in + the return of the foreign currencyThis is a simple, but hopefully effective way of expressing the view that there are two separateand distinct risks present within the decision to invest outside of the base currency. The motiveof risk reduction is therefore to hedge to whatever extent decided upon the return of the foreigncurrency. From this basic premise, we can extrapolate the following:Return (unhedged) = Return (asset) + Return (currency)andReturn (hedged) = Return (asset) + Return (hedge currency)The overall aim remains the same, and that is to reduce the overall risk of the portfolio,maximizing the total or absolute return in the process. In other words, it is to boost theportfolio’s Sharpe ratio, which is usually defined as the (annual) excess return as a proportionof the (annual) standard deviation or risk involved.It should be noted from this formula however that some investors balk at the idea of hedgingon the simplistic view that the hedge cost automatically reduces not just the hedged returnof the asset but the asset’s total return in base currency terms. This is not necessarily the
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Portfolio Risk (Standard Deviation)
11.2Unhedged international equity
11.0
Fully hedged international equity
10.810.6Volatility dominates diversification
10.4
Contribution of currencies tototal portfolio risk
Diversification dominates volatility
10.210.09.80%
4% 8%
12% 16% 20% 24% 28% 32% 36% 40% 44% 48% 52%International Exposure
Figure 8.1 USD balanced investor, 1973–1999: EAFE + Canada combined to 60% US equity/40%US bond portfolio
case. Actually, the converse can be argued, namely that the hedge reduces or eliminates anypossible currency loss. Whether or not the investor hedges, there is the foreign currency returnto be considered. That may add or detract from the asset return in foreign currency terms,and therefore may in turn boost or reduce the asset return in domestic currency terms. Thehedging cost component will clearly depend on a number of variables, including the currencyhedging benchmark and the financial instruments that can be used, but has clear parameters.The potential unhedged currency loss is theoretically limitless.ExampleAs an example of risk reduction, we will take an average balanced investor with internationalexposure. As Figure 8.1 shows, looking from 1973 to 1999, currency hedging can significantlyreduce the overall risk profile of the portfolio.
8.5 SELECTING THE CURRENCY HEDGING BENCHMARKA crucial decision for portfolio managers who want to manage their currency risk, whetheractively or passively, is the selection of their currency hedging benchmark. After all, when weare talking about managing currency risk, we are really talking about establishing whether ornot there may be a need to hedge out that currency risk. Using a currency hedging benchmarkis a more disciplined and rigorous way of managing currency risk than either not hedging orat the other extreme conducting all currency hedging on a discretionary and “gut feel” basis.There are four main currency hedging benchmarks used by institutional investors, which canbe divided into:
r 100% hedged benchmarkr 100% unhedged benchmarkr Partially hedged benchmarkr Option hedged benchmark
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Being 100% hedged is usually not the optimal strategy, apart from in exceptional cases.Equally, using a currency hedging benchmark of 100% unhedged would seem to defeat thepurpose of managing currency risk, again apart from in exceptional cases. A further consideration is that many funds are not allowed to use options as they are viewed as a speculativefinancial instrument, ironically in the same way that some corporations are also not allowed touse them. This still leaves them however with the choice of three possible currency hedgingbenchmarks of 100% hedged, 100% unhedged or partially hedged. The primary instrument forsuch hedging would be the forward for passive currency management, though active currencymanagers would no doubt have greater flexibility, both in the currencies in which they canoperate and the financial instruments they can use.Currency hedging benchmarks of 0% or 100% are known as asymmetrical or polar benchmarks and have obvious limitations. With a polar benchmark, an active currency manager isable to take positions only in one direction. As a result, their ability to add value is also limited.For example, it is extremely difficult for a currency manager to be able to add value operatingunder an unhedged currency benchmark when foreign currencies are appreciating because themanager is generally unable to take on additional foreign currency exposure. The best themanager can do is to mimic the benchmark by holding the unhedged benchmark exposure andavoiding hedging. Similarly, when operating under a fully hedged benchmark, it is difficult fora manager to add value when foreign currencies are falling.Adoption and use of benchmarks depends critically on the currency risk management style,for which the type of fund is clearly a key determinant. For instance, a pension fund managermay use a fully hedged or alternatively unhedged currency benchmark to either reduce riskon the one hand or minimize transaction costs on the other. Meanwhile, the active currencymanager will seek a partially hedged benchmark, preferably 50%, to give them as muchflexibility and room as possible with which to be able to add value. With such a symmetricalbenchmark, active currency managers can take advantage of both bull and bear markets in theircurrencies. In the context of relative returns, it should therefore be of no surprise that there isgood evidence to suggest that symmetrical benchmarks have consistently added more “alpha”than their asymmetrical counterparts.ExampleA classic example of a group of international investors that typically use one specific type ofcurrency hedging benchmark is that of international equity funds, which generally either donot hedge or adopt unhedged benchmarks. Though the technical details are different betweenthese two approaches, they amount to the same thing. There may be some debate as to whatshould be the optimum currency benchmark for an international equity fund in terms of thehedging ratio. However, what is clear is that the hedging ratio for these should in theorybe higher than for those funds with only a small portion of international equity risk, on thesimple premise that the higher the currency risk the higher the required hedge ratio. Despitethis, unhedged currency benchmarks remain very popular among this group of investors. Inpart, this is because many fund managers still suggest that the long-term expected returnof currencies is zero and in addition that currency hedging generates unnecessary transactioncosts. Furthermore, the idea that investing in a country means investing in the currency remainsprevalent within international equity funds.For the reasons that we have already outlined earlier in this chapter, we would dispute boththese views. The very idea of long term is subjective for one thing. For another, currency
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weakness in the short term may lead to intolerable mark-to-market and tracking error deterioration. Finally, the trading and analytical dynamics of currency and asset markets are as wesuggested different from one another, ergo the two risks they represent should be treated andmanaged separately and independently from one another. Generally speaking therefore, wewould suggest having an unhedged currency benchmark would be inappropriate, even supposing the currency risk management motive was for risk reduction rather than adding alpha.Using a partially hedged benchmark can undoubtedly reduce the portfolio’s overall risk andthus boost its Sharpe and information ratios.A possible exception to this broad disagreement with the general idea of using unhedgedbenchmarks is where the fund has only a small portion of its assets in international as opposedto domestic equities. Indeed, if the international allocation of an equity fund is below 10–15%,it may not make sense to have a hedging benchmark above that allocation as that might infact add to the portfolio’s risk while detracting from the return. In other words, under certaincircumstances it may make sense to use an unhedged benchmark for those equity funds withonly a small international allocation. Generally however, if an international equity fund hasan international allocation that significantly exceeds its benchmark weight, this representsunnecessary currency risk that should be managed.
8.6 RELATIVE RETURNS – ADDING ALPHAAsset managers who are focused on absolute returns when managing their currency risk tend touse strategies that are characterized by risk reduction, adopting a passive currency managementapproach in order to achieve this. By contrast, funds that are focused on relative returns tend tomanage currency risk more actively. Their aim is after all to outperform an unhedged position,or in some cases the hedged benchmark, in other words to “add alpha”. In this, there is no“right” and “wrong”. It depends completely on the risk management style of the fund and whatrisk approach it takes towards both the underlying assets and also the embedded currency risk.8.6.1 Active Currency ManagementActive currency management around a currency benchmark means the fund has given either theasset manager or a professional currency overlay manager the mandate to “trade” the currencyaround the currency hedging benchmark for the explicit purpose of adding alpha to the totalreturn of the portfolio.With active currency management, the emphasis should be on flexibility, both in terms of theavailability of financial instruments one can use to add alpha and also in terms of the currencyhedging benchmark. On the first of these, an active currency manager should have access to abroad spectrum of currency instruments in order to boost their chance of adding value. Similarly,their ability to add value is significantly increased by the adoption of a 50% or symmetricalcurrency hedging benchmark rather than by a 100% hedged or 100% unhedged benchmark.8.6.2 Adding “Alpha”The motive of risk reduction is primarily defensive, in that it seeks to defend or maintain theportfolio’s return within a given tolerance of overall risk. That for adding “alpha” on the otherhand is quite different, in so much as “alpha” refers to the excess return generated by an activecurrency manager relative to a passive hedging programme.
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Economic theory suggests that the long-term return of a currency is zero, so how can anactive currency manager add value or “alpha”? There appear to be two aspects to this question.Firstly, currency markets are dominated by short-term movement. Thus, while their long-termreturn may be zero, their short-term returns (and losses!) may be significant. Secondly, it shouldbe remembered that the same theory that suggested there were fundamental equilibrium levelsfor currencies also suggests that their long-term returns are zero. While not rejecting such atheory outright, it should surely be treated with some care, put in this context.Indeed, there is a fine – and increasing – body of academic work that suggests that contrary totheory, managing currency risk can indeed add “alpha”. Among these, I will draw out severalnotable examples. Firstly, while formulating his “Universal Hedging Policy” in 1989, FisherBlack suggested that currency was, contrary to theory, not a zero sum game and investors couldindeed increase their returns by holding currency inventories. Needless to say, this contradictedthe widely held view that currencies could not provide added value because currency marketswere perfectly efficient. A relatively short time after that, Mark Kritzman put forward theview that active currency managers could take advantage of the apparent serial correlationin currency returns. Subsequent research by Taylor (1990) and Silber (1994) targeted markettrends as being behind persistent positive returns from currency managers.Two further research reports that should be mentioned are those by Strange (1998, updated2001) and The Frank Russell Company (2000). In the first case, the survey by Brian Strange, aspublished in Pensions and Investment (15/6/98), entitled “Do Currency Managers Add Value?”stated that of the 152 individual currency overlay programmes managed by 11 firms, these produced an average of 1.9% per year over a 10-year review period from 1988 to 1998, while simultaneously reducing the risk of the portfolio. In other words, not only did currency managersconsistently add value, but their action of seeking to manage currency risk also helped lower theoverall risk profile of the portfolio, thus boosting the Sharpe ratio from both sides! The secondexample is that of the Frank Russell study of May 2000 entitled “Capturing Alpha throughActive Currency Overlay”, which analysed the historical performance of currency overlay mandates and confirmed the view that managing currency risk does indeed add value or “alpha”.As noted above, a host of empirical studies have proven conclusively that active currencymanagement can indeed boost the portfolio’s return, both on an absolute basis and in this contextrelative to not hedging, in contrast to classical exchange rate theory. In line with this, a numberof studies have been published suggesting clear market inefficiencies, which might thereforebe taken advantage of by active currency managers. For instance, the 1993 study by Kritzman,suggesting that the discount/premium of the currency forward contract “systematically andsignificantly overestimated the subsequent change in the spot rate”. Kritzman also introducedthe concept of so-called “bilateral asymmetry”, referring to a bias by risk-averse investors forthe perceived predictable returns of the interest rate differential as opposed to the unpredictablereturns of the currency. Work by Choie (1993) supported these findings. Overall, a body ofinformed opinion has developed, supportive of the view that active currency management canadd value.After finally admitting that currency markets may offer profit potential, whether over theshort or long term, academic theorists have suggested that such profit opportunities may exist incurrency markets because there are some currency market participants that are not solely or evenmainly motivated by profit. Classical theory suggests rational currency market participants aresolely profit seeking and moreover offset each other, with the result that any outstanding profitopportunities are instantly arbitraged away. Thus, from this, they seek to explain the existenceof sustained profit opportunities within currency markets by suggesting that nonprofit-seeking
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currency market participants such as central banks, tourists and national or corporate Treasurieseffectively distort pricing. To me, such a view appears more reflective of the guesswork ofsomeone who does not actually know the answer but is afraid to own up. Currency marketsgenerate profits because it is the theory that they should not that is wrong rather than thecurrency market itself.Active currency management can add value because there is value to be had in currencymarkets, plain and simple. Within this, an active currency manager will clearly favour the mostflexibility possible to add that value, both in terms of the currency benchmark that they haveto operate under and the currencies and financial instruments with which they are allowedto trade. For the active currency manager, the foreign currency return is not just a matter ofcurrency translation of the underlying asset, but also of the excess return or alpha that thecurrency manager is able to add. The alpha an active currency manager generates is usuallymeasured against an unhedged position. However, probably a truer idea of the alpha the activecurrency manager generates would come from comparing their returns to those of a passivecurrency management strategy of maintaining the benchmark hedge ratio. Historically, thetypical mandate has allowed managers to vary the hedge ratio between 0 and 100% regardlessof the benchmark.8.6.3 Tracking ErrorJust as corporations have to deal with “forecasting error” in terms of the deviation of forecastexchange rates relative to the actual future rate, so investors have to deal with “trackingerror” within their portfolios, which is the return of the portfolio relative to the investmentbenchmark index being used. Within this, there is “expected” and “realized” tracking error.Expected tracking error is as the name suggests determined before the fact – ex ante – whereasthe realized tracking error is determined after the fact.Determining the relevance of tracking error is also a function of comparing the portfolio’shedging strategy with a random strategy, which creates hedge/don’t hedge signals with equalprobability on a regular basis. Using polar benchmarks – i.e. 0% or 100% hedged – the equalprobability of the outcome of the random strategy suggests that hedge deviations will bezero in half the cases and 100% in half the cases. However, with a partially hedged currencybenchmark, the deviations will vary in direct proportion to the ratio of the benchmark. Forinstance, for a symmetrical or 50% hedged currency benchmark, the deviations will be 50%from each side of the benchmark.From this, we can gather two things, firstly that the tracking error – or the deviation – isa function of the hedged ratio used for benchmarking and secondly that the tracking errorfor a partially hedged benchmark should be less than that for a polar benchmark. Indeed,generally, the tracking error for a symmetrical or 50% currency hedging benchmark should bearound 70% of the tracking error using polar benchmarks. Expressed differently, the trackingerror of a polar benchmark should be 1.41 (square root of 2) times higher than that of a50% hedged benchmark. The advantage of a symmetrical or 50% currency hedged benchmarkfor a portfolio manager is that it reduces the tracking error of the portfolio and also enablesthem to participate in both bull and bear markets compared to the polar benchmark where theparticipation is limited to either/or.Tracking error can