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76 / September 2013 • BenefitsCanada
A forward-looking approach to
strategic currency hedging
By
e
John Osborn and Kendra Kaake
getty images
I
nvestors with significant international
holdings often hedge their currency
exposure to protect their portfolios
against movements in the exchange
rate. This strategy is intended to provide an
investor with returns that approximate
the return of the local market by removing
the impact of any appreciation or depreciation of the local currency vis-à-vis their
home currency.
But for Canadian-based investors who hold
equities in currencies commonly considered to
be reserve currencies—such as the U.S. dollar
and the British pound sterling—historical
analysis has shown that an unhedged strategy
can decrease the volatility of returns. This is
because the investor’s exposure to the exchange
rate (CAD/USD, in the U.S. case) is negatively
correlated with foreign equities in reserve
currencies, and any loss on the foreign asset is
mitigated by currency exposure.
Investors who believe in PPP can follow
a simple dynamic rule to enhance returns
With the intent of minimizing regret,
many investors choose a hedge ratio on a
“basket” of foreign equity—in other
words, hedging a portion of the portfolio
to lower the effect of foreign exchange
movements. However, this approach may
mask the relationship between individual
currency pairs, which may not be obvious
in an aggregate basket.
A better solution could be to
implement a strategic currency hedging
policy that incorporates the following
three key elements:
1.evaluate the Canadian currency
against select reserve currencies
rather than a basket of foreign
currencies;
2.base the policy on forward-looking
beliefs rather than historical data; and
3.adopt a strategy based on purchasing
power parity (PPP) to enhance returns.
(PPP is based on the “law of one price”
stating that exchange rates between
currencies are in equilibrium when their
purchasing power is the same.)
Those investors who believe that
the Canadian dollar is essentially a
commodity currency and will therefore
continue to show pro-cyclical behaviour
(i.e., appreciating and depreciating in line
with commodities) can reduce equity
volatility by retaining foreign currency
exposure, especially to the U.S. dollar. In
addition, investors who believe in PPP
can follow a simple dynamic rule to
enhance returns.
Commodity Versus Reserve
Currencies
Commodity currencies, such as the
Canadian and Australian dollars, tend to
show pro-cyclical behaviour. Reserve
currencies, on the other hand, tend to
show anti-cyclical behaviour—
particularly when they benefit from a
flight to quality during times of economic
and financial stress. For Canadian and
Australian investors, therefore, exposure
to foreign currencies is anti-cyclical and
reduces risk.
Based on the premise that commodity
currencies are pro-cyclical and reserve
currencies are anti-cyclical, an analysis
covering the period 1999 to 2013 (with
selective analysis back to 1970) found:
• negative correlations between equities
and currency surprise exposures to the
U.S. dollar, euro, yen, pound and Swiss
franc (Currency surprise is the
difference between changes in
exchange rates to be expected on the
basis of the pure interest rate
differential and the actual changes in
exchange rates.);
• an especially high negative correlation
between equities and currency surprise
exposure to the U.S. dollar;
• lesser, but still negative, correlations
between equities and currency surprise
exposures to the pound and yen; and
• a positive or zero correlation between
equities and currency surprise exposure
to the Australian dollar, given that
the Australian dollar and the base
Canadian dollar are both commodity
currencies.
A History Lesson
24-month rolling correlation between
hedged equities and currency surprise
of select currencies
(Japanese Yen, Euro and U.S. dollar), 1999—2013
Source: BNY Mellon. Six-country hedged (CAD) equity portfolio includes 4% AUD, 60% USD, 14% EUR, 9% JPY,
4% CHF, 9% GBP. (Currency surprise equals unhedged minus hedged equity return.)
78 / September 2013 • BenefitsCanada
A Russell Investments analysis covering
the 24-month rolling correlation of the
S&P/TSX Composite Index with U.S.
dollar currency surprise for the 14-year
period between 1999 and 2013 found
that the unhedged equity portfolio had
the lowest volatility. Furthermore, its
volatility (12.5%) was below that of the
S&P/TSX Composite Index for the same
period (15.4%). This is true for the full
1999–2013 period, the pre-2008 crash
period and the post-2008 period,
illustrating that currency exposure
dampens U.S. equity market volatility
for Canadian-based investors.
Extending the analysis back to 1970,
the correlation remained negative for
most of that time, except during the early
1970s. The 1970s is a particularly
interesting period: the Canadian dollar
became a floating currency in 1970, the
U.S. dollar went off the gold standard in
1971, and the oil crisis hit in 1973. The
oil crisis led to inflation and recession, so
the premise that pro-cyclical currencies
are affected by commodity prices is
questionable in this type of environment.
Therefore, should a commodity-led
inflationary period cause recession at
some future date, the implication may be
that Canadian-based investors should
hedge at least part of their foreign
currency exposures.
Investment managers have traditionally
evaluated the currency hedging decision
by examining historical relationships. But,
as the chart on page 78 shows, currency
relationships change.
Canadian-based investors who believe
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the Canadian dollar will continue to be
pro-cyclical should use an unhedged
default hedge ratio (where the default
hedge ratio refers to the static, or passive,
portfolio hedge). If this forward-looking
belief changes or becomes uncertain,
investors should consider changing their
currency hedging policies.
A Dynamic Approach
Research has shown PPP to be the most
dependable value factor in currency
markets over the long term. Since many
factors affect exchange rates in the short
and medium terms, PPP is a poor choice
as an active management tool, but its
long-term nature may be helpful in
selectively adjusting a strategic policy.
The Russell analysis covering the
1999–2013 period determined that,
at some point, every currency was
undervalued and overvalued, and then
eventually returned to parity. However,
the cycles can be lengthy: an optimal
policy that seeks to minimize volatility
does produce undesirable returns for long
periods of time.
Can investors use the characteristics of
exchange rate movements relative to PPP
to improve the performance of a static
hedge ratio? One simple rule will test this
idea: hedge exposure to currencies that
are 20% or more overvalued, remain fully
exposed to currencies that are more than
20% undervalued, and return to the
default hedge policy only when the
currencies get back to within +/- 5%
around parity.
This rule is designed to implement a
simple process to occasionally adjust a
static strategic policy. A simulation from
1999 (the inception of the euro) to 2013
resulted in 15 trades over this 14-year
period, in addition to the five trades
(representing the basket of currencies
within the portfolio) at the start of the
period. That’s one trade per year, on
average, after inception. Relative to a
default 50% hedge policy, the simulation
provided 1.4% annualized additional
return with similar portfolio volatility.
The dynamic PPP strategy has the
intuitive appeal of being equilibriumbased and forward-looking—it does not
rely on historical patterns or anomalies,
and it considers the prevailing level of
expected future exchange rates. Also, the
strategy does not force investors to trade:
it trades only when currencies are
significantly out of line with PPP, when
8/20/13 2:12 PM
the risks and opportunities are the
greatest. If currencies are well behaved
and remain near parity, no trades take
place, which supports low currency
volatility in the portfolio.
Intuition may suggest that currency
exposure will increase a portfolio’s
volatility because currencies are volatile.
However, this is not the case for
Canadian-based equity investors, as the
diversification effect of foreign currency
exposure on equity portfolios is strong
and persistent enough to more than offset
the volatility of currencies. These
investors, therefore, should remain
unhedged, except perhaps to the
Australian dollar. Combining an
unhedged static hedge ratio with a
dynamic PPP adjustment provides an
opportunity for investors to both reduce
risk and enhance returns.
John Osborn (now retired) was a senior
consultant, and Kendra Kaake is a senior
investment strategist, Canada institutional,
TO HEDGE OR NOT TO HEDGE?
If you’re a Canadian investor...
• USD appreciates (i.e., USD/CAD rate declines, CAD/USD rate rises)
• Canadian investor earns currency gain on unhedged USD asset
•If the USD/CAD and equity markets are positively correlated, then the Canadian
investor’s exposure to the CAD/USD rate is negatively correlated and any loss on
the USD asset is mitigated by currency exposure
•In this case, the Canadian investor should not hedge USD
If you’re a U.S. investor...
• CAD depreciates (i.e., USD/CAD rate declines, CAD/USD rate rises)
• U.S. investor suffers currency loss on unhedged CAD asset
•If USD/CAD and equity markets are positively correlated, the U.S. investor loses
twice in an equity bear market
Example: in the period from April 2008 to February 2009:

USD/CAD rate declined to 0.79 from 0.99 (CAD/USD rate rose to 1.27 from 1.01)

currency surprise impact was -14% (unhedged exposure exacerbated equity
market decline)
•In this case, the U.S. investor should hedge CAD
with Russell Investments. kkaake@russell.com
 
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