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2023 Curriculum CFA Program Level III Portfolio Management and Wealth Planning

Currency Management: An Introduction

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Introduction

Globalization has been one of the most persistent themes in recent history, and this theme applies equally to the world of finance. New investment products, deregulation, worldwide financial system integration, and better communication and information networks have opened new global investment opportunities. At the same time, investors have increasingly shed their “home bias” and sought investment alternatives beyond their own borders.

The benefits of this trend for portfolio managers have been clear, both in terms of the broader availability of higher-expected-return investments as well as portfolio diversification opportunities. Nonetheless, investments denominated in foreign currencies also bring a unique set of challenges: measuring and managing foreign exchange risk. Buying foreign-currency denominated assets means bringing currency risk into the portfolio. Exchange rates are volatile and, at least in the short to medium term, can have a marked impact on investment returns and risks—currency matters. The key to the superior performance of global portfolios is the effective management of this currency risk.

This reading explores basic concepts and tools of currency management. Section 2 reviews some of the basic concepts of foreign exchange (FX) markets. The material in subsequent sections presumes an understanding of these concepts. Section 3 examines some of the basic mathematics involved in measuring the effects of foreign-currency investments on portfolio return and risk. Section 4 discusses the strategic decisions portfolio managers face in setting the target currency exposures of the portfolio. The currency exposures that the portfolio can accept range from a fully hedged position to active management of currency risk. Section 5 discusses some of the tactical considerations involving active currency management if the investment policy statement (IPS) extends some latitude for active currency management. A requisite to any active currency management is having a market view; so this section includes various methodologies by which a manager can form directional views on future exchange rate movements and volatility. Section 6 covers a variety of trading tools available to implement both hedging and active currency management strategies. Although the generic types of FX derivatives tools are relatively limited—spot, forward, option, and swap contracts—the number of variations within each and the number of combinations in which they can be used is vast. Section 7 examines some of the issues involved in managing the currency exposures of emerging market currencies—that is, those that are less liquid than the major currencies. Section 8 presents a summary.

Learning Outcomes

The member should be able to:

  1. analyze the effects of currency movements on portfolio risk and return;

  2. discuss strategic choices in currency management;

  3. formulate an appropriate currency management program given financial market conditions and portfolio objectives and constraints;

  4. compare active currency trading strategies based on economic fundamentals, technical analysis, carry-trade, and volatility trading;

  5. describe how changes in factors underlying active trading strategies affect tactical trading decisions;

  6. describe how forward contracts and FX (foreign exchange) swaps are used to adjust hedge ratios;

  7. describe trading strategies used to reduce hedging costs and modify the risk–return characteristics of a foreign-currency portfolio;

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

  9. discuss challenges for managing emerging market currency exposures.

Summary

In this reading, we have examined the basic principles of managing foreign exchange risk within the broader investment process. International financial markets create a wide range of opportunities for investors, but they also create the need to recognize, measure, and control exchange rate risk. The management of this risk starts with setting the overall mandate for the portfolio, encoding the investors’ investment objectives and constraints into the investment policy statement and providing strategic guidance on how currency risk will be managed in the portfolio. It extends to tactical positioning when portfolio managers translate market views into specific trading strategies within the overall risk management guidelines set by the IPS. We have examined some of these trading strategies, and how a range of portfolio management tools—positions in spot, forward, option, and FX swap contracts—can be used either to hedge away currency risk, or to express a market opinion on future exchange rate movements.

What we have emphasized throughout this reading is that there is no simple or single answer for the “best” currency management strategies. Different investors will have different strategic mandates (IPS), and different portfolio managers will have different market opinions and risk tolerances. There is a near-infinite number of possible currency trading strategies, each with its own benefits, costs, and risks. Currency risk management—both at the strategic and tactical levels—means having to manage the trade-offs between all of these various considerations.

Some of the main points covered in this reading are as follows:

  • In professional FX markets, currencies are identified by standard three-letter codes, and quoted in terms of a price and a base currency (P/B).

  • The spot exchange rate is typically for T + 2 delivery, and forward rates are for delivery for later periods. Both spot and forward rates are quoted in terms of a bid–offer price. Forward rates are quoted in terms of the spot rate plus forward points.

  • An FX swap is a simultaneous spot and forward transaction; one leg of the swap is buying the base currency and the other is selling it. FX swaps are used to renew outstanding forward contracts once they mature, to “roll them forward.”

  • The domestic-currency return on foreign-currency assets can be broken into the foreign-currency asset return and the return on the foreign currency (the percentage appreciation or depreciation of the foreign currency against the domestic currency). These two components of the domestic-currency return are multiplicative.

  • When there are several foreign-currency assets, the portfolio domestic-currency return is the weighted average of the individual domestic-currency returns (i.e., using the portfolio weights, which should sum to one)

  • The risk of domestic-currency returns (its standard deviation) can be approximated by using a variance formula that recognizes the individual variances and covariances (correlations) among the foreign-currency asset returns and exchange rate movements.

  • The calculation of the domestic-currency risk involves a large number of variables that must be estimated: the risks and correlations between all of the foreign-currency asset returns and their exchange rate risks.

  • Guidance on where to target the portfolio along the risk spectrum is part of the IPS, which makes this a strategic decision based on the investment goals and constraints of the beneficial owners of the portfolio.

  • If the IPS allows currency risk in the portfolio, the amount of desired currency exposure will depend on both portfolio diversification considerations and cost considerations.

    • Views on the diversifying effects of foreign-currency exposures depend on the time horizon involved, the type of foreign-currency asset, and market conditions.

    • Cost considerations also affect the hedging decision. Hedging is not free: It has both direct transactional costs as well as opportunity costs (the potential for favorable outcomes is foregone). Cost considerations make a perfect hedge difficult to maintain.

  • Currency management strategies can be located along a spectrum stretching from:

    • passive, rules-based, complete hedging of currency exposures;

    • discretionary hedging, which allows the portfolio manager some latitude on managing currency exposures;

    • active currency management, which seeks out currency risk in order to manage it for profit; and to

    • currency overlay programs that aggressively manage currency “alpha.”

  • There are a variety of methods for forming market views.

    • The use of macroeconomic fundamentals to predict future currency movements is based on estimating the “fair value” for a currency with the expectation that spot rates will eventually converge on this equilibrium value.

    • Technical market indicators assume that, based on market psychology, historical price patterns in the data have a tendency to repeat. Technical indicators can be used to predict support and resistance levels in the market, as well as to confirm market trends and turning points.

    • The carry trade is based on violations of uncovered interest rate parity, and is also based on selling low-yield currencies in order to invest in high-yield currencies. This approach is equivalent to trading the forward rate bias, which means selling currencies trading at a forward premium and buying currencies trading at a forward discount.

    • Volatility trading uses the option market to express views on the distribution of future exchange rates, not their levels.

  • Passive hedging will typically use forward contracts (rather than futures contracts) because they are more flexible. However, currency futures contracts are an option for smaller trading sizes and are frequently used in private wealth management.

  • Forward contracts have the possibility of negative roll yield (the forward points embedded in the forward price can work for or against the hedge). The portfolio manager will have to balance the advantages and costs of hedging with forward contracts.

  • Foreign-currency options can reduce opportunity costs (they allow the upside potential for favorable foreign-currency movements). However, the upfront option premiums must be paid.

  • There are a variety of means to reduce the cost of the hedging with either forward or option contracts, but these cost-reduction measures always involve some combination of less downside protection and/or less upside potential.

  • Hedging multiple foreign currencies uses the same tools and strategies used in hedging a single foreign-currency exposure; except now the correlation between residual currency exposures in the portfolio should be considered.

  • Cross hedges introduce basis risk into the portfolio, which is the risk that the correlation between exposure and its cross hedging instrument may change in unexpected ways. Forward contracts typically have very little basis risk compared with movements in the underlying spot rate.

  • The number of trading strategies that can be used, for hedging or speculative purposes, either for a single foreign currency or multiple foreign currencies, is near infinite. The manager must assess the costs, benefits, and risks of each in the context of the investment goals and constraints of the portfolio. There is no single “correct” approach.