Unbundling currency risk

Foreign exchange markets once again face uncertain times. Heightened exchange rate volatility is driving increasing interest on the part of institutional investors in currency hedging strategies focused on mitigating the impact currency fluctuations have on investment returns.

The integration of robust and efficient currency hedging tools and policies are a vital component of the investment process to successfully align currency risk management strategies with overall risk and return investment objectives.

Why hedge currency risk?
The diversification benefits from holding foreign investments are well understood by investment professionals. The reward from taking the accompanying currency risk is not. Unmanaged translation currency risk is not compensated by higher expected investment returns. This has important implications for investment managers in defining investment strategies and setting risk and return performance objectives.

Selecting an optimal hedge benchmark
Before embarking on a currency risk hedging program it’s important to clearly define and separate risk reduction and return enhancement objectives and ensure both are clearly alignment with the overall investment objectives.

The contribution of foreign currency risk to total investment return risk—the currency effect—depends upon the relative asset and currency volatility and the correlation between the two. The weight of these factors and the optimal hedge ratio will vary in each case but it is possible to make some general observations.

For example, the currency effect for unhedged well diversified global equity e.g. MSCI World Index is lower than of the underlying assets. In this scenario one can expect diminishing marginal improvement in risk by increasing the hedge ratio beyond a certain point. Within this framework a neutral ‘least regret’ passive currency hedge of 50% is appropriate.

For investments in international bonds, the picture is much clearer. The return volatility of investment grade fixed income holdings is low relative to currencies and as such the underlying portfolio does not benefit from currency risk. A hedge benchmark of 100% is appropriate in these instances.

Designing a passive hedging program
The key to reducing foreign currency risk is to create foreign currency liabilities through the currency hedge that aim to offset the foreign currency translation gains or losses on the underlying foreign currency assets. By far the most common tools used to achieve this result are plain foreign exchange forward contracts.

Careful consideration and design of the program rules are necessary to ensure the selection of the best fit set of parameters to meet the target currency hedging strategy. Among the key considerations are the following:

• the performance benchmark;
• which currencies to hedge;
• how much of each currency exposure to hedge;
• the hedge target ratio and tolerance bands for each currency;
• how often the hedges are rebalanced;
• the hedge tenor;
• the minimum exposure size to hedge and the minimum trade size;
• the nature of the underlying investments—liquidity and volatility; and
• management of cash flows arising from the hedging.

Residual risks and performance expectations
The aim of any passive currency hedging program is to ‘substantially’ offset the translation gains or losses on foreign currency assets. Even a well designed, implemented and controlled hedging program will not be perfect. Residual risks will result in performance variance against a theoretically perfectly hedged benchmark. Here are some of the key residual risk areas to be aware of.

Residual spot risk – The value of the currency exposures to hedge are moving targets as the value of the underlying assets change. As currency hedge rebalancing is a reactive process it is inevitable there will always be some residual unhedged currency exposure.
Basis risk – the relative movement of spot exchange rates used to revalue the underlying assets and the forward exchange rates used to hedge those exposures may not be 1:1.
Cash drag from accrued unrealized hedge gain and loss – all currency hedges need to be rolled periodically to realize the hedging cash-flows. The longer the duration of the hedge the greater the potential to accrue larger unrealized gains or losses.

Outsourcing versus in-house
A traditional view of passive currency hedging is often a purely mechanical process that adds little value to a pure investment management process. This is not true. Managing currency risk, even passively, requires significant experience, upfront investment in specialized labour, IT infrastructure and supporting ancillary work steams in operations, compliance and legal teams. Appointing a specialist passive currency hedging service provider is an attractive alternative to end to end in-house management when viewed in a comprehensive risk, expertise and transparent cost framework.

Mark Hogg is director, FX product development, RBC Dexia Investor Services Trust