Objectives of Active Currency Management Passive Currency - - PowerPoint PPT Presentation
Objectives of Active Currency Management Passive Currency Management Foreign Currency Return Gain Unhedged 50% hedged Foreign currency Foreign currency appreciation depreciation Fully hedged Unhedged: accept return volatility as
Foreign currency depreciation Foreign currency appreciation Foreign Currency Return Gain Loss Unhedged Fully hedged 50% hedged Unhedged: accept return volatility as trade-off for diversification Fully hedged: accept cash flow volatility as trade-off for zero return volatility Partial hedge: used to target strategic allocation to foreign currency at the total portfolio level
For illustration purposes only
Create asymmetric outcome
Foreign currency depreciation Foreign currency appreciation Foreign Currency Return Gain Loss Unhedged Fully hedged 50% hedged
Dynamic hedge
Dynamic Hedge: increases foreign currency exposure relative to passive target Objective: to increase capture rate of foreign currency appreciation and reduce negative cash flow Dynamic Hedge: reduces foreign currency exposure relative to passive target Objective: to floor or limit the cost of foreign currency depreciation
Gain relative to passive
For illustration purposes only
Why would a fund choose a dynamic currency strategy relative to a linear passive strategy? Concerned about higher currency volatility /risk
1
Fund SAA has high allocations to offshore assets
2
Fund SAA has high allocations to illiquid assets
3
Generate excess returns
Foreign currency depreciation Foreign currency appreciation Foreign Currency Return Gain Loss Unhedged Fully hedged Passive hedge Currency Alpha + Passive hedge Unconstrained Currency Alpha: varies both the level and mix of foreign currency exposure Objective: to generate positive excess returns
For illustration purposes only
Why would a fund choose an unconstrained currency alpha strategy relative to simple passive strategy? Not concerned about higher currency volatility or fund liquidity / negative cash flow, want to maximise return opportunity set
1
Currency alpha: is highly capital efficient has low implementation costs is operationally simple
2
Currency alpha returns are uncorrelated to traditional asset returns
3
Foreign currency depreciation Foreign currency appreciation Foreign Currency Return Gain Loss Unhedged Fully hedged 50% hedged The “Ideal Outcome” is possible by allocating risk to both a dynamic hedge and an unconstrained alpha program Objective: capture all the gains from foreign currency appreciation and reduce the cost of foreign currency depreciation to zero
For illustration purposes only
Ideal Outcome
Dynamic hedge increases foreign currency exposure to capture gains from appreciation and reduce negative cash flow / decreases foreign currency exposure to limit the cost of foreign currency depreciation by increasing positive cash flow. Allocation to unconstrained alpha increases the overall risk adjusted return with the objective of at least offsetting the cost of asymmetry
Foreign currency depreciation Foreign currency appreciation Foreign Currency Return Gain Loss
For illustration purposes only
Ideal Outcome
Objective is to get as close to the ideal outcome as possible, but by varying the risk allocation, portfolio preferences may also be satisfied Higher hedging allocation Higher alpha allocation Higher dynamic hedging allocation increases the asymmetry and the capture rate of foreign currency gains – the cost of asymmetry can be high Higher alpha allocation increases the overall risk adjusted return from holding foreign currency exposure, by reducing the cost of asymmetry
How do you determine the allocation between alpha and asymmetry?
Depends on the funds objectives for holding foreign currency exposure at the total portfolio level
minimising negative cash flow is important, then allocate more risk to dynamic (asymmetric) hedging
unconstrained alpha
which may partly be due to exchange rate fluctuations.
reinvestment of dividends and/or income and other earnings. Any gross of fees performance does not include fees and charges and these can have a material detrimental effect on the performance of an investment.
Strategies which have a higher performance aim generally take more risk to achieve this and so have a greater potential for the returns to be significantly different than expected.
currency of the underlying investments and the base currency (i.e. the reporting currency) of the portfolio. These techniques may not eliminate all the currency risk.
investment may result in a disproportionately large movement in the price of the derivative investment.
in accounting, dealing, settlement and custody may arise.
is employed by the portfolio and losses would be greater than if leverage were not employed.