Currency Strategies

borrow in low-yield currencies and invest in high-yield currencies
accept some downside risk and forgone some upside profits
minimum-variance hedge ratio (optimal ratio)
Currency Strategies
Foreign Exchange Markets
Influence on asset return & risk
Strategic Decisions
FX swap
currency option
exchange rate: price currency/ base currency (P/B)
usually priced out to four decimal places
T+2 settlement
EUR&GBP: EUR is base currency
GBP & other currencies: GBP is base currency
AUD/NZD & Not EUR/ GBP: AUD/NZD is base currency
USD & other currencies: USD is base currency
bid & offer price (both based on price currency)
bid price: investor is willing to sell the base currency &the counterparty is willing to buy one unit of the base currency
offer price: investor is willing to buy the base currency & the counterparty is willing to sell one unit of the base currency
quote: based on points, the difference between the forward exchange rate and spot exchange rate
mark-to-market value
1. Create an equal and offsetting forward position
2. Determine the rate for offsetting forward position
3. Calculate the cash flow at settlement day = (new spot rate - forward rate) × contract size
4. Calculate the PV of cash flow (currency of cash flow and discount rate must match)
long position: then appreciate, gain
short position: then depreciate, gain
和currency swap的比较
用处:可以用来roll forward contracts
matched swap: two legs are of equal size, use mid-market spot exchange rate
mismatched swap: one leg can be larger than the other, adjust to spot exchange rate
相同:需要交换principal amount
不同:no interim interest payments and are nearly always of much shorter term
one asset
multiple assets
Add exchange rate risk exposure to the portfolio usually adds to domestic-currency return variance
negative correlations among variables will help reduce the overall portfolio's risk through diversification effects
Rfx is calculated as the change in the directly quoted exchange rate, domestic currency is the price currency
Tactical Decisions
选择hedge或不hedge的原因 (适用PM)
IPS - currency risk management risk policy
确定optimal weights
不进行currency management的原因
进行currency management的原因
in the long run currency effects cancel out to zero (mean revert)
an efficient currency market is a zero-sum game
cost will decrease return
inefficient currency markets and movements could have a dramatic impact on short-term return
target proportion of currency exposure to be passively hedged
latitude for active currency management
frequency of hedge rebalancing
currency hedge performance benchmark
hedging tools permitted
portfolio optimization over fully hedged returns
selection of active currency exposures
optimize the expected foreign-currency asset risk-return trade-off
diversification: depend on foreign-currency asset composition
link movements in exchange rates, interest rates and inflation rate hold in long-run
适合哪些投资者:very long investment horizon and few immediate liquidity needs
negative correlation
both bonds and currency react strongly to interest rate,little benefit for fixed income portfolios,更需要hedge
global equity portfolio相对不需要hedge
trading cost
non-US investors: under hedge (<100%)
US investors: fully hedge
currencies like USD can act as a safe haven and appreciate in times of market stress
opportunity cost
bid-ask spread
currency options: requires the payment of up-front premiums
forward: roll down forward with FX swap, which generate cash inflow or outflow
administrative infrastructure cost and overhead cost
Passive Hedging: keep the portfolio's currency exposures close those of a benchmark portfolio
Discretionary Hedging
Active Currency Management (an extension of discretionary hedging)
Currency Overlay
is a rules-based approach
minimize tracking errors
need periodic rebalancing
has some limited discretion (percentage of foreign-currency market value) to vary from the neutral position
no allowance for unlimited speculation
risk management system
discretionary的主要目的是protect the portfolio from currency risk;其次是enhance overall portfolio returns
active management的主要目的是take currency risks and manage them for profit (add alpha)
一般需要external managers
和 take foreign exchange as an asset class的区别
hedging & alpha function mandates可以拆分
currency overlay is limited to the currency exposures already in the foreign asset portfolio
foreign currency as asset class is free to take exposures in any currency pair
have portfolio fully-hedged but then also add an external currency overlay manager to portfolio
alpha mandates: should have minimum correlation with both the major asset classes and the other alpha sources in the portfolio
可以添加多种overlay strategies
several currency overlay managers with different styles
fund-of-funds approach
short term
risk averse
have immediate income or liquidity needs
hedging is cheap
financial markets are volatile
which FX exposures to accept and mange within these discretionary limits
based on economic fundamentals
based on technical analysis
based on carry trade
in the long-run, real exchange rate will converge to its fair value
in short- to medium-term, influenced by factors
interest rate
market risk premium
in a liquid, freely traded market the historical price data can be helpful in projecting future price movements
historical patterns have a tendency to repeat
technical analysis does not attempt to determine where market prices should trade but will trade
identify market trend and turning points
carry trade是violation of uncovered interest rate parity
forward rate bias
return distribution has a pronounced negative skew
uncovered interest rate parity
yield spread advantage for high-yielding currency is offset by depreciation of the high-yield currency
策略:buy high-yield currency & sell low-yield currency
Forward rate should be an unbiased predictor of future spot rates
forward premium: >0, overstates the amount of appreciation of the base currency
forward discount:<0, overstates the amount of depreciation
covered interest rate parity
if base currency has a lower interest rate than price currency, forward premium
if base currency has a higher interest rate than price currency, forward discount
funding currencies are typically the safe haven currencies and investment currencies are typically currencies perceived to be higher risk
Volatility Trading
delta heding
hedging away the option position's exposure to price risk of the underlying FX spot rate
both an ATM put and call
both an OTM put and call
the cost is cheaper
speculative traders: often want to be net-short volatility
hedgers: be net-long volatility
FX Swaps
Currency options
roll yield
matched swap
mismatched swap
remove the opportunity cost
forwards can be customized
futures might not be available for less liquid currencies
futures require up-front margin or additional variation margin, therefore need careful monitoring
forward contracts are more liquid than futures for trading in large sizes
static hedge
dynamic hedge
will avoid transaction costs but will tend to accumulate unwanted currency risk
need periodical rebalancing
degree of risk aversion
tolerance for active trading
confidence in a particular market view
spot leg
forward leg
取决于base currency的交易方向,sell -- bid price; buy -- offer price
price on the mid-market spot exchange rate
spot leg
forward leg
取决于base currency的交易方向,sell -- bid price; buy -- offer price
当forward size更大时,使用forward leg所确定的price
positive: buy base currency at forward discount or sell it at forward premium
negative: buy base currency at forward premium or sell it at forward discount
roll yield影响hedge ratio
negative, lower hedge ratio
risk-neutral manager would not hedge
risk-averse manager might still implement the hedge(
positive, more likely be fully hedged or even over-hedged
roll cost> hedge gain
Trading Strategies (cost-reduction measures)
protective put (OTM option)
risk reversal
based on market view over-/under-hedging
结论:increase hedge ratio if base currency depreciate, decrease hedge ratio if the base currency appreciated
long a call option + short a put option
long collar = short a risk reversal
put spread
seagull spread
Exotic options
long OTM put option + write deeper-OTM put option
zero costs: alter strike price or notional amounts or both of them
short position (short wings)
long position (long wings)
long ATM put + write OTM put and OTM call
write ATM call + long OTM put and OTM call
are designed to customize the risk exposures of client
knock-in/knock-out options
binary options
more expensive but more gain
1. identify base currency,使用的derivatives针对base currency
2. identify transaction side
3. 调节strike prices & notional amounts towards a zero-cost structure
Multiple Currencies Hedge
cross hedge
proxy hedge
move currency risk from one foreign currency to another foreign currency
remove foreign currency risk by hedging it back to the investor's domestic currency
主旨:minimize the tracking error between the value of the hedged asset and the hedging instrument
basis risk is brought into the portfolio when a direct currency hedge is replaced with an indirect hedge
EM Currencies Hedge
non-deliverable forwards
higher trading costs (wider bid-offer spreads) than major currencies
increased likelihood of extreme market events and severe illiquidity under stressed market conditions
cash settled in the non-controlled currency rather than physically settled
non-controlled currency is usually USD or some other major currency
credit risk of an NDF is lower
sudden changes in government policy can lead to sharp movements in NDF rate (tail risk)
amount is converted to non-controlled currency use future spot rate