Expert View
How to manage currency risk
Using a dynamic approach to react to changing market conditions
By investing in global assets, investors need to
consider risks and opportunities of both the
underlying asset and the foreign exchange rate
in order to estimate the total return of their
investment. The foreign exchange rate is the
price of one currency expressed in another. The
theoretical explanatory framework for currency
fluctuations is provided by different economic
theories, which derive exchange rates and their
fluctuations from factors such as the price level,
income or interest rate at home and abroad. The
three major theories in this regard are the
Mundell-Fleming model, the interest rate parity
and the purchasing power parity theory.
Where does currency risk come from?
In practice, the price of a currency in a system
of floating exchange rates is determined by the
supply and demand of market participants in
the global foreign exchange market. Market
participants are basically internationally active
companies, banks, investors and central banks.
In a system of fixed exchange rates the central
bank acts as a monopolistic market participant
and defines the exchange rate by trading in its
own currency – known as market intervention.
Therefore, foreign exchange opportunities and
risks are only present in a system of floating
exchange rates, since a currency’s appreciation
or depreciation is based on its supply and
demand by market participants.
Why manage currency risk?
In comparison with other asset categories (i.e.
stocks or bonds), it becomes apparent that
currencies do not provide a conventional risk
premium such as dividends or interest
payments. However, currency fluctuations have
a substantial influence on the total return of a
[]
the currency effect is
“ As
unstable over time there
is no constant optimal
choice of either hedging
or not hedging.
”
global investment in GBP. This
influence is higher, the lower
the return and risk of the
underlying asset are. While on
average around 25% of the total
risk in an international stock
portfolio can be attributed to
currency fluctuations, the
currency risk’s portion of the
total risk in a bond portfolio is
as high as 90%.
To hedge, or not to hedge?
When considering currency
risk management investors are
essentially faced with two
choices: either to leave the risk
unhedged or to hedge the risk. Whichever
choice is made, the investor remains exposed
to risk: either the currency risk of depreciation
losses or the hedging risk of high liquidity
requirements for the hedging instrument in
the case of an appreciation of the foreign
currency. As the currency effect is unstable
over time there is no constant optimal choice
of either hedging or not hedging. Therefore,
the most effective way of dealing with the
problem is to manage currency risk
dynamically, and hedge the currency exposure
according to market conditions.
How to identify a trend in a currency
successfully
The essential elements to successful dynamic
currency hedging are market timing and
direction. The key here is to identify the start of
a trend in a currency, and whether the trend is
appreciating or depreciating. Trend following
systems using the exchange rate itself as the
single input parameter address this question
very systematically and more reliably than
economic models as only if the exchange rate
moves is the decision made whether to leave
the foreign currency exposure unhedged and
gain currency profits, or to hedge the exposure
and protect it from a depreciating currency.
The chart shows dynamic hedging as blue
shading: in periods of currency appreciation the
hedge ratio should be near to zero and in
periods of depreciation it should be near to
100%. The payout profile of a dynamic hedging
strategy is like that of an option and therefore,
can be seen as the realized volatility based
alternative to an implied volatility based option
strategy.
Expert View
What does a systematic risk management
approach look like?
Using a quantitative approach additionally
gives a high level of confidence regarding
repeatable results in the future, as
mathematical models will always repeat their
results as long as the input is the same, i.e. if
markets move the same way in the future as
they did in the past and the system detected the
trend properly in the past it will do so in the
future. Exchange rates will always have periods
of appreciation and periods of depreciation as
long as they are not fixed. In a world of change,
risk management has to be flexible and able to
react to changing market conditions, as change
is the only thing that happens constantly.
Tindaro Siragusano,
Head of Private Banking
& Asset Management,
Berenberg
September 2013 / PensionsInsight
41
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