CFA –Level III

Currency Management: An Introduction

- Presented by Utkarsh Jain

• Effects of currency movements on portfolio
risk and return.

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• An investment in assets priced in a currency
other than the investor's domestic currency (a
foreign asset priced in a foreign currency) has two
sources of risk and return:
(1) the return on the assets in the foreign
currency and
(2) the return on the foreign currency from any
change in its exchange rate with the investor's
domestic currency. These returns are
multiplicative and an investor's returns in
domestic currency can be calculated as:
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• A Djiboutian (DJF) investor holds an
international portfolio with beginning
investments of USD 1,253,000 and EUR
2,347,800. Measured in the foreign
currencies these investments appreciate 5%
and depreciate 7% respectively.

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• Additional information:
Beginning Spot Exchange Beginning Forward Ending Spot
Rate Exchange Rate Exchange Rate

DJF/USD 179.54 DJF/USD 185.67 DJF/USD 192.85

EUR/DJF 0.00416 EUR/DJF 0.00413 EUR/DJF 0.00421

The ending value of the EUR investment is

closest to:

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A) DJF 575,000.
B) EUR 2,500,000.
C) EUR 2,200,000.

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• A Djiboutian (DJF) investor holds an
international portfolio with beginning
investments of USD 1,253,000 and EUR
2,347,800. Measured in the foreign
currencies these investments appreciate 5%
and depreciate 7% respectively.
• Additional information

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Beginning Spot Exchange Beginning Forward Ending Spot
Rate Exchange Rate Exchange Rate

DJF/USD 179.54 DJF/USD 185.67 DJF/USD 192.85

EUR/DJF 0.00416 EUR/DJF 0.00413 EUR/DJF 0.00421

The unhedged return to the investor of the

European investment is closest to:
A) -6%.
B) -8%.
C) -5%

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• Discuss strategic choices in currency
management

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• Arguments made for not hedging currency
risk include:
– It is best to avoid the time and cost of
hedging or trading currencies.
– In the long-run, unhedged currency
effects are a zero-sum game; if one
currency appreciates, another must
depreciate.

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 – In the long-run, currencies revert to a
theoretical fair value.
• The argument for active management of currency
risk is that, in the short run, currency movement
can be extreme, and inefficient pricing of
currencies can be exploited to add to portfolio
return.
• Many foreign exchange (FX) trades are dictated
by international trade transactions or central
bank policies.
• These are not motivated by consideration of fair
value and may drive currency prices away from
their fair value.

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

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

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• Discretionary hedging allows the manager
to deviate modestly from passive hedging by
a specified percentage.
• An example is allowing 5% deviations
from the hedge ratio that would match a
currency's exposure to the benchmark
exposure.
• The goal is to reduce currency risk while
allowing the manager to pursue modest
incremental currency returns relative to the
benchmark.
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• Active currency management allows a
manager to have greater deviations from
benchmark currency exposures.
• This differs from discretionary hedging in
the amount of discretion permitted and the
manager is expected to generate positive
incremental portfolio return from managing
a portfolio's currency exposure.
• The goal is to create incremental return
(alpha), not to reduce risk.

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• A currency overlay is a broad term
covering the outsourcing of currency
management.
• At the extreme, the overlay manager will
treat currency as an asset class and may take
positions independent of other portfolio
assets.
• Seeking incremental return, an overlay
manager who is bearish on the Swedish
krona (SEK) for a portfolio with no
exposure to the SEK would short the SEK.
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• The manager is purely seeking currency
alpha (incremental return), not risk
reduction.
• Overlay mangers can also be given a pure
risk reduction mandate or restricted to risk
reduction with modest return enhancement.

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• A U.S. investor who holds a £2,000,000
investment wishes to hedge the portfolio
against currency risk. The investor should:
A) buy £2,000,000 worth of futures for U.S.
dollars.
B) sell $2,000,000 worth of futures for British
pounds.
C) sell £2,000,000 worth of futures for U.S.
dollars.

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• Which of the following comments is most
accurate?
A) Discretionary currency hedging allows wider
deviations from the strategic hedging than active
currency management.
B) A cost/benefit analysis of whether to hedge
currency should include all of the following:
bid/asked transaction costs, option premiums,
back office and compliance expenses.
C) Currency volatility becomes a more significant
issue in global portfolios over a longer time
horizon as returns compound.
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Formulate an appropriate currency
management program given market facts
and client objectives and constraints.

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• In conclusion, the factors that shift the strategic
decision formulation toward a benchmark
neutral or fully hedged strategy are:
1. A short time horizon for portfolio objectives.
2. High risk aversion.
3. A client who is unconcerned with the opportunity costs of
missing positive currency returns.
4. High short-term income and liquidity needs.
5. Significant foreign currency bond exposure.
6. Low hedging costs.
7. Clients who doubt the benefits of discretionary management

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• Which of the following portfolios would most
likely follow a passive currency hedging
strategy?
A) One with more confidence in the portfolio
manager and high income needs.
B) One with a shorter time horizon and
higher liquidity needs.
C) One very concerned with minimizing
regret and higher allocation to equity
investments.
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Compare active currency trading strategies
(fundamental, technical, carry, and
volatility-based).

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• 1) Economic Fundamentals
• This approach assumes that, in the long term,
currency value will converge to fair value.
• For example, a fundamental approach may
assume purchasing power parity will determine
long-run exchange rates.
• Several factors will impact the eventual path of
convergence over the short and intermediate
terms.

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• Increases in the value of a currency are associated
with currencies:
• That are more undervalued relative to their
fundamental value.
• That have the greatest rate of increase in their
fundamental value.
• With higher real or nominal interest rates.
• With lower inflation relative to other countries.
• Of countries with decreasing risk premiums.
• Opposite conditions are believed to be associated
with declining currency values.
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• 2) Technical Analysis
• Technical analysis of currency is based on
three principals:
1)Past price data can predict future price
movement and because those prices reflect
fundamental and other relevant information,
there is no need to analyze such information.

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 2)Fallible human beings react to similar
events in similar ways and therefore past
price patterns tend to repeat.
3)It is unnecessary to know what the
currency should be worth (based on
fundamental value); it is only necessary to
know where it will trade.

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• 3) The Carry Trade
• A carry trade refers to borrowing in a lower
interest rate currency and investing the
proceeds in a higher interest rate currency.
Three issues are important to understand the
carry trade.
• Covered interest rate parity (CIRP) holds by
arbitrage and establishes that the difference
between spot (S0) and forward (F0) exchange
rates equals the difference in the periodic
interest rates of the two currencies.
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 rates of the two currencies.
• The currency with the higher interest rate
will trade at a forward discount, F0 < S0
• The currency with the lower interest rate
will trade at a forward premium, F0 > S0

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• The carry trade is based on a violation of
uncovered interest rate parity (UCIRP).
• UCIRP is an international parity relationship
asserting that the forward exchange rate
calculated by CIRP is an unbiased estimate of the
spot exchange rate that will exist in the future. If
this were true:
– The currency with the higher interest rate will
decrease in value by the amount of the initial interest
rate differential.
– The currency with the lower interest rate will increase
in value by the amount of the initial interest rate
differential.
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• If these expectations were true, a carry
trade would earn a zero return.
• Because the carry trade exploits a violation
of interest rate parity, it can be referred to
as trading the forward rate bias. Historical
evidence indicates that:
• Generally, the higher interest rate currency has
depreciated less than predicted by interest rate parity or
even appreciated and a carry trade has earned a profit

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• 4) Volatility Trading
• Volatility or vol trading allows a manager
to profit from predicting changes in
currency volatility.
• Recall from Level I and Level II that delta
measures the change in value of an option's
price for a change in value of the underlying
and that vega measures change in value of
the option for changes in volatility of the
underlying.
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• Vega is positive for both puts and calls
because an increase in the expected volatility
of the price of the underlying increases the
value of both puts and calls.

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• Delta hedging entails creation of a delta-
neutral position, which has a delta of zero.
• The delta-neutral position will not gain or
lose value with small changes in the price of
the underlying assets, but it will gain or lose
value as the implied volatility reflect in the
price of options changes.
• A manager can profit by correctly
predicting changes in volatility.

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• A manager expecting volatility to decrease
should enter a short straddle by selling both
of these options.
• If volatility declines, the options will fall in
net value. The options can be repurchased at
lower prices for a profit.
• A strangle will provide similar but more
moderate payoffs to a straddle.
• Out of-the-money calls and puts with the
same absolute delta are purchased.
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• Currency trading based on economic
fundamentals would be most likely to sell a
currency forward if the country issuing the
currency is experiencing:
A) increasing real rates of return.
B) rising relative inflation.
C) declining levels of relative risk in the
economy

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Describe how changes in the factors
underlying active trading strategies affect
tactical trading decisions.

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• Which scenario would most likely lead a portfolio
manager to buy a foreign currency in the
forward market?
A) A portfolio that is overweighted in assets
denominated in that currency.
B) An active manager implementing a carry trade
when the currency being bought as the higher
relative yield.
C) An active currency manager who is
underweighted in assets denominated in that
currency.

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Describe how forward contracts and FX
swaps are used to adjust hedge ratios.

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 Typically, forward contracts are preferred
for currency hedging because:
• They can be customized, while futures
contracts are standardized.
• They are available for almost any currency
pair, while futures trade in size for only a
limited number of currencies.

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• Futures contracts require margin which
adds operational complexity and can require
periodic cash flows.
• Trading volume of FX forwards and swaps
dwarfs that of FX futures, providing better
liquidity.

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• A hedge can be a static hedge, which is
established and held until expiration, or a
dynamic hedge, which is periodically
rebalanced.
• The choice of hedging approach should
consider:
• Shorter term contracts or dynamic hedges
with more frequent rebalancing tend to
increase transaction costs but improve the
hedge results.

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• Hedging also exposes the portfolio to roll
yield or roll return.
• Roll yield is a return from the movement
of the forward price over time toward the
spot price of an asset.
• It can be thought of as the profit or loss on
a forward or futures contract if the spot
price is unchanged at contract expiration.

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• A U.S.-based investor has purchased a
15,000,000 peso office building in Mexico.
He has hedged his investment by selling
forward futures at $0.1098/peso. Two
months later, the futures exchange rate has
fallen to $0.0921/peso. The investor's net
change in the futures position is:
A) $265,500.
B) $1,647,000.
C) -$265,500.

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• The cost to hedge a long position in the EUR
is reduced by:
A) negative roll yield.
B) lower relative interest rates in the euro
zone.
C) forward euro exchange rates are below
the spot exchange rates.

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Describe trading strategies used to reduce
hedging costs and modify the risk adjusted
“return characteristics of a foreign-currency
portfolio.

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• To reduce hedging cost, the manager can
increase the size of trades that earn positive
roll yield and reduce the size of trades that
earn negative roll yield.
• Forward hedging also incurs opportunity cost.
• Locking in a forward price to hedge currency
risk will eliminate downside currency risk but
also will eliminate any upside opportunity for
gain from changes in exchange rates.

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Discretionary or option-based hedging
strategies are designed to reduce
opportunity cost.

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 1) Over- or under-hedge with forward
contracts based on the manager's view.
• If the manger expects the CHF to
appreciate, she can reduce the hedge ratio,
hedging less than the full exposure to CHF
risk.
• If the CHF is expected to depreciate, she
can increase the hedge ratio, hedging more
than the full exposure to CHF risk.

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• If successful, this strategy creates positive
convexity; gains will be increased and losses
reduced. This is a relatively low cost
strategy.
• The rest of this discussion proceeds from
roughly highest to lowest initial option cost.

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2) Buy at-the-money (ATM) put options (also
called protective puts or portfolio insurance).

• This strategy provides asymmetric protection,

eliminating all downside risk and retaining all
upside potential.
• But an at-the-money option is relatively
expensive and has only time value (no intrinsic
value).
• This strategy has the highest initial cost but no
opportunity cost.

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3) Buy out-of-the-money (OTM) put options.
• An ATM put would have a delta of
approximately 0.50, called a 50-delta put
because the sign of the delta is ignored with
this terminology.
• Out-of-the-money puts have deltas that are
smaller in magnitude than 0.50, so a 35-delta
put is out of the money and a 25-delta put is
further out of the money.

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 but also offer less downside protection.
• The manger will have downside CHF
exposure down to the strike price of the puts.
• Compared to buying ATM protective puts,
this strategy reduces the initial cost of the
hedge but does not eliminate all downside
risk.

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 4) Put spread.
• Buy OTM puts on the CHF and sell puts that
are further out of the money, (e.g., buy a 35-delta
put and sell a 25-delta put).
• There is downside protection, which begins at
the strike price of the purchased puts, but if the
CHF falls below the lower strike price of the put
sold, that downside protection is lost.
• This strategy reduces the initial cost and also
reduces downside protection compared to buying
out-of-the money put options only.

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 5) Seagull spread.
• This is a put spread combined with selling
a call (e.g., buy a 35-delta put, sell a 25-delta
put, and sell a 35-delta call).
• Compared to the put spread, only this
hedge has less initial cost and the same down
side protection, but limits upside potential.

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Describe the use of cross-hedges, macro-
hedges, and minimum-variance-hedge ratios
in portfolios exposed to multiple foreign
currencies.

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• A cross hedge (sometimes called a proxy
hedge) refers to hedging with an instrument
that is not perfectly correlated with the
exposure being hedged.
• Cross hedges also introduce additional risk
to hedging.
• When the correlation of returns between
the hedging instrument and the position
being hedged is imperfect, the residual risk
increases.
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• A macro hedge is a type of cross hedge that
addresses portfolio-wide risk factors rather
than the risk of individual portfolio assets.
• One type of currency macro hedge uses a
derivatives contract based on a fixed basket of
currencies to modify currency exposure at a
macro (portfolio) level.
• The currency basket in the contract may not
precisely match the currency exposures of the
portfolio, but it can be less costly than hedging
each currency exposure individually.

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• The minimum-variance hedge ratio (MVHR) is
a mathematical approach to determining the
hedge ratio.
• When applied to currency hedging, it is a
regression of the past changes in value of the
portfolio (RDC) to the past changes in value of the
hedging instrument to minimize the value of the
tracking error between these two variables.
• The hedge ratio is the beta (slope coefficient)
of that regression.
•

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• Because this hedge ratio is based on historical
returns, if the correlation between the returns
on the portfolio and the returns on the hedging
instrument change, the hedge will not perform as
well as expected.
•

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• The MVHR can be used to jointly optimize
over changes in value of RFX and RFC to
minimize the volatility of RDC.

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• To illustrate this use of the MVHR, consider
the case of a foreign country where the economy
is heavily dependent on imported energy.
• Appreciation of the currency (+RFX) would
make imports less expensive, which is likely to
decrease production costs, increasing profits
and asset values (+RFC).
• Strong positive correlation between RFX and
RFC increases the volatility of RDC. A hedge ratio
greater than 1.0 would reduce the volatility of
RDC.

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Discuss special considerations for managing
emerging market currency exposures.

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• The majority of investable asset value and
FX transactions are in the largest developed
market currencies.
• Transactions in other currencies pose
additional challenges because of:
1. Higher transaction costs, high markups
2. The increased probability of extreme
events.

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• Non-deliverable forwards (NDFs): Emerging
market governments frequently restrict
movement of their currency into or out of the
country to settle normal derivative transactions.
Such countries have included Brazil (BRL),
China (CNY), and Russia (RUB).
• NDFs are an alternative to deliverable
forwards and require a cash settlement of gains
or losses in a developed market currency at
settlement rather than a currency exchange.

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• Which of the following statements regarding
hedging of emerging market currencies is
least accurate?
A) Hedging costs for managers who buy
emerging market currencies are increased
by the relatively high interest rates in
emerging markets.
B) Hedging cost varies with normally large
bid/asked spreads followed by infrequent
periods of even higher spreads.

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C) Tail risk and contagion both refer to
relatively infrequent events that increase the
difficulty of hedging emerging market
currencies

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Thank you!

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