Transcript Document

RESEARCH
The Currency Hedging Conundrum
David Turkington
Portfolio and Risk Management Group
State Street Associates
Overview
> Passive versus active currency management
> Why is currency risk important?
> Schools of thought
> Optimal currency hedging: In-sample and out-of-sample results
Passive versus Active Currency Management
> Currency exposure is an inescapable feature of investment in foreign
markets.
> The passive currency hedging policy should be driven by the volatility
currency exposure introduces to a portfolio, not by the expected returns of
currencies.
> Views about currency returns should dictate tactical decisions, not policy
decisions.
> Active currency management strategies seek to generate excess return by
exploiting certain characteristics of currency markets.
Passive versus Active Currency Management
Overlay
Alpha
Passive
Active
(Expected Return = 0)
(Expected Return ≠ 0)
>
Portfolio Hedging
>
Traditional Active
Hedging
>
Optimal Hedge
Ratios
>
Symmetrical
Active Hedging
>
Active Cross
Hedging
>
Alpha Strategies
Why is currency risk important?
> Even if currency fluctuations “wash out” in the long run, they contribute
to interim risk and may substantially increase the magnitude and/or
likelihood of drawdowns.
Wealth
This view assumes that investors
are only concerned about what
happens at the end of their
investment horizon.
Time
Wealth
In reality, most investors care
about what happens along the
way.
Time
Mechanisms for Hedging Currency Risk
> Currency hedging is achieved through the use of derivative instruments.
Forward contracts are often the most practical due to their high liquidity
and customizable nature.
> In particular, short positions in forward contracts can be used to offset
exchange rate movement embedded in the portfolio.
> A currency forward contract locks in a price today to buy/sell currency at
a future date, taking into consideration the current spot rate, interest
rate differential between two countries, and time.
What is the best hedge ratio for foreign
currency exposure?
A. 100% - Currencies just add unwanted risk to the portfolio.
B. 0% - Why hedge? Currencies add diversification.
C. The hedge ratio that minimizes overall portfolio risk.
D. 50% - Never 100% right, but never 100% wrong either!
Why is Currency Risk Important?
Schools of Thought – 100% Hedged
“Currencies simply contribute to portfolio volatility.”
Unhedged MSCI Switzerland
Unhedged
MSCI
Switzerland
Unhedged
MSCI
US
Unhedged
MSCI
Switzerland
MSCI Swiss from CHF Perspective
Unhedged MSCI Swiss from EUR Perspective
0.55% Reduction to
Annualized Risk
CHF Standard Deviation*: 17.58%
EUR Standard Deviation*: 17.03%
80.00%
2.80
70.00%
2.60
60.00%
50.00%
Unhedged MSCI Switzerland
2.20
40.00%
2.00
30.00%
1.80
20.00%
1.60
10.00%
1.40
0.00%
1.20
-10.00%
1.00
-20.00%
0.80
-30.00%
1996
De
c95
Ju
n9
De 6
c96
Ju
n9
De 7
c97
Ju
n9
De 8
c98
Ju
n9
De 9
c99
Ju
n0
De 0
c00
Ju
n0
De 1
c01
Ju
n0
De 2
c02
Ju
n0
De 3
c03
Ju
n0
De 4
c04
Ju
n05
Portfolio Value
2.40
1997
1998
1999
2000
2001
2002
2003
2004
* Annualized Standard Deviation of Monthly Returns
Date
The right exposure to currencies can actually provide portfolio diversification,
therefore reducing overall portfolio risk
Why is Currency Risk Important?
Schools of Thought – 0% Hedged
“Currencies add diversification to my portfolio.”
3.78% Additional
Annualized Risk
Unhedged
MSCIUS
US
Unhedged MSCI
MSCI US from USD Perspective
Unhedged MSCI US from EUR Perspective
Unhedged MSCI US
USD Standard Deviation*: 15.84%
EUR Standard Deviation*: 19.61%
60.00%
4.50
50.00%
4.00
40.00%
3.50
20.00%
2.50
10.00%
2.00
0.00%
1.50
-10.00%
1.00
-20.00%
0.50
-30.00%
-40.00%
-
1996
De
c9
Ju 5
nDe 9 6
c9
Ju 6
nDe 9 7
c9
Ju 7
nDe 9 8
c9
Ju 8
nDe 9 9
c9
Ju 9
nDe 0 0
c0
Ju 0
n0
De 1
c0
Ju 1
nDe 0 2
c0
Ju 2
n0
De 3
c0
Ju 3
nDe 0 4
c0
Ju 4
n05
Portfolio Value
30.00%
3.00
1997
1998
1999
2000
* Annualized Standard Deviation of Monthly Returns
Date
If currency returns are expected to wash out over the long run:
>
>
Expected Return = Zero
Additional volatility is uncompensated!
2001
2002
2003
2004
Why is Currency Risk Important?
Schools of Thought – 50% Hedged
“Minimum regret” portfolio hedging policy
Seeks to avoid:
> 100% hedged when foreign currencies experience periods of
appreciation
> 0% hedged when foreign currencies experience periods of
depreciation
Unhedged
Fully hedged
Techniques for Managing Currency Risk
Passive Hedging
> Goal is to control potential exchange rate risk
> Typical hedge ratio is between 0% – 100%
> Hedge ratios applied uniformly across all currencies
Techniques for Managing Currency Risk
Currency Risk and Diversification
> Some currency exposure is beneficial, insofar as it introduces diversification
to the portfolio. Hence, a 100% hedge ratio generally produces sub-optimal
results.
> Currency exposure affects a portfolio’s risk in two ways:
> it introduces volatility, and
> it introduces diversification.
> The net effect of these two influences determines the optimal fraction of
currency exposure to hedge in order to minimize a portfolio’s risk.
Techniques for Managing Currency Risk
Minimum Variance Hedge Ratio
Modern Portfolio Theory takes these factors into account to identify a
single, risk-minimizing hedge ratio.
Standard Deviation
10.0%
Portfolio Volatility:
10%
Currency Volatility:
12%
Correlation:
60%
9.5%
β = 0.60 * (0.10 / 0.12) = 50%
9.0%
8.5%
8.0%
7.5%
0%
20%
40%
60%
80%
Percent of Portfolio Hedged
100%
Techniques for Managing Currency Risk
Minimum Variance Hedge Ratio
Portfolio Volatility:
10%
Currency Volatility:
12%
Optimal Hedge Ratio (various correlations)
12.0%
Standard Deviation
11.0%
Risk-minimizing hedge ratio
10.0%
9.0%
8.0%
corr = 0.5
7.0%
corr = 0.6
corr = 0.7
6.0%
0%
20%
40%
60%
Percent of Portfolio Hedged
80%
100%
Techniques for Managing Currency Risk
Optimal Passive Hedge
The extent to which currencies introduce volatility and/or
diversification to a portfolio depends on:
> the asset/liability composition of the portfolio,
> the base currency of the investor, and
> the specific currencies to which the portfolio is exposed.
Techniques for Managing Currency Risk
Optimal Currency-Specific Hedge Ratios
> Each currency interacts with asset markets in a unique way. It is not
necessarily optimal to hedge the same proportion of every currency.
Sample Pension Plan Currency Exposures
(60% Global Equity, 40% Global Bonds)
AUD
Optimal Hedge Ratios
Pension Plan, US Investor
Unhedged
Fully Hedged
USD
CAD
SEK
CHF
NZD
NOK
USD
EUR
JPY
GBP
EUR
CHF
CAD
SEK
AUD
GBP
NZD
NOK JPY
0
20
40
60
80
100
Techniques for Managing Currency Risk
Hedge Ratios and Portfolio Efficiency
The Modern Portfolio Theory framework can be extended to identify a set
of currency-specific hedge ratios that jointly minimize portfolio risk.
Expected Return
With Currency Hedging
Without Currency Hedging
Standard Deviation
Optimal Hedge Ratios: In-Sample Results
Risk minimizing hedge ratios
(January 1985 - September 2009)
Australia
0%
20%
20%
20%
20%
20%
0%
-20%
0%
-20%
-14%
0%
-54%
Canada
20%
0%
20%
20%
20%
20%
-20%
0%
0%
-19%
-7%
0%
-46%
Germany
20%
20%
0%
20%
20%
20%
-20%
-20%
0%
-20%
-20%
-20%
-100%
UK
20%
20%
20%
0%
20%
20%
-20%
-20%
-9%
0%
-12%
-20%
-81%
Japan
20%
20%
20%
20%
0%
20%
-20%
-20%
-20%
-20%
0%
-20%
-100%
US
20%
20%
20%
20%
20%
0%
-20%
-20%
-18%
-20%
-11%
0%
-89%
Unhedged Stdev
Hedged Stdev
Risk Reduction
16.87%
15.35%
1.52%
16.18%
15.05%
1.13%
19.12%
14.81%
4.31%
19.15%
15.94%
3.21%
21.66%
15.59%
6.07%
19.12%
15.80%
3.32%
F statistic (σ2/σ2)
Rejection F 95%
Significant
1.21
1.21
No
1.16
1.21
No
1.67
1.21
Yes
1.44
1.21
Yes
1.93
1.21
Yes
1.46
1.21
Yes
MSCI Australia
MSCI Canada
MSCI Germany
MSCI UK
MSCI Japan
MSCI USA
AUD
CAD
EUR
GBP
JPY
USD
Portfolio Hedge Ratio
Source: Kinlaw, W. and M. Kritzman. “Optimal currency hedging in- and out-of-sample” The Journal of Asset Management,
Vol 10, No 1, 22-36.
Optimal Hedge Ratios: Out-of-Sample Results
Out-of-sample average risk minimizing hedge ratios
(January 1985 - September 2009)
Australia
0%
20%
20%
20%
20%
20%
0%
-20%
-7%
-11%
-15%
-14%
-66%
Canada
20%
0%
20%
20%
20%
20%
-19%
0%
-5%
-11%
-14%
-4%
-54%
Germany
20%
20%
0%
20%
20%
20%
-20%
-20%
0%
-18%
-19%
-19%
-96%
UK
20%
20%
20%
0%
20%
20%
-20%
-20%
-7%
0%
-18%
-19%
-84%
Japan
20%
20%
20%
20%
0%
20%
-19%
-20%
-12%
-18%
0%
-19%
-89%
US
20%
20%
20%
20%
20%
0%
-20%
-20%
-7%
-13%
-18%
0%
-78%
Unhedged Stdev
Hedged Stdev
Risk Reduction
16.87%
15.00%
1.87%
16.18%
14.91%
1.27%
19.12%
14.47%
4.65%
19.15%
15.72%
3.43%
21.66%
15.59%
6.07%
19.12%
15.64%
3.48%
F statistic (σ2/σ2)
Rejection F 95%
Significant
1.26
1.21
Yes
1.18
1.21
No
1.75
1.21
Yes
1.48
1.21
Yes
1.93
1.21
Yes
1.49
1.21
Yes
MSCI Australia
MSCI Canada
MSCI Germany
MSCI UK
MSCI Japan
MSCI USA
AUD
CAD
EUR
GBP
JPY
USD
Portfolio Hedge Ratio
Source: Kinlaw, W. and M. Kritzman. “Optimal currency hedging in- and out-of-sample” The Journal of Asset Management,
Vol 10, No 1, 22-36.
Black Swan Events?
A digression on “sigma”
> A “1-sigma” event is a one standard deviation move, a “2-sigma” event is
a two standard deviation move, and so forth.
> When investors describe events using sigma, they are implicitly
assuming that returns follow a normal, “bell curve” distribution.
> On average, we would expect:
> a 1-sigma event to occur on 1 trading day out of 8,
> a 2-sigma event to occur on 1 trading day out of 44, and
> a 3-sigma event to occur on 1 trading day out of 741.
> In the summer of 2007, a high-profile hedge fund announced that it had
experienced two 25-sigma events in a row.
How often would we expect a 7-sigma event
to occur?
A. Approximately 1 trading day in 300 years
B. Approximately 1 trading day in 300,000 years
C. Approximately 1 trading day in 3,000,000 years
D. Approximately 1 trading day in 3,000,000,000 years
Source: Dowd, K., J. Cotter, C. Humphrey, and M. Woods. “How Unlikely Is 25-Sigma?” The Journal of Portfolio
Management, Summer 2008.
Putting N-sigma events in perspective
> “A 5-sigma event corresponds to an expected occurrence of less than
just one day in the entire period since the end of the last Ice Age,” or
approximately 1 day every 14,000 years.
> “A 7-sigma event corresponds to an expected occurrence of just once in
a period approximately five times the length of time that has elapsed
since multi-cellular life first evolved on this planet,” or approximately 1
day every 3 billion years.
> An 8-sigma event corresponds to an expected occurrence of once in “a
period that is considerably longer than the entire period since the Big
Bang.”
> “The probability of a 25-sigma event is comparable to the probability of
winning the lottery 21 or 22 times in a row.”
Source: Dowd, K., J. Cotter, C. Humphrey, and M. Woods. “How Unlikely Is 25-Sigma?” The Journal of Portfolio
Management, Summer 2008.
Out-of-Sample Results: 5-Year Drawdowns
Maximum 5-year Drawdowns
January 1985 - September 2009
Five Year - Unhedged
Five Year - Hedged
Australia
-28.01%
-23.43%
Canada
-20.81%
-19.43%
Germany
-19.12%
-12.37%
UK
-13.84%
-7.73%
Japan
-27.54%
-30.56%
US
-20.05%
-15.75%
Source: Kinlaw, W. and M. Kritzman. “Optimal currency hedging in- and out-of-sample” The Journal of Asset Management,
Vol 10, No 1, 22-36.
Why do hedge ratios vary across countries?
> For both German and Canadian investors, commodities are negatively
correlated with a capitalization-weighted foreign currency basket. These
coefficients are -0.10 and -0.14, respectively. On average, when
commodity prices rise, a basket of foreign currencies falls.
> The German stock market (net consumers of commodities) is negatively
correlated with commodities; this coefficient is -0.20. For Germans, an
increase in commodity prices impacts domestic stock returns and
foreign currency returns in the same way: both fall. Hence, foreign
currencies do not diversify German equities.
> The Canadian stock market (net producers of commodities) is positively
correlated with commodities; this coefficient is 0.10. Hence, for
Canadians, an increase in commodity prices impacts domestic stock
returns and foreign currency returns differently: stocks rise and foreign
currencies fall. Hence, foreign currencies do diversify Canadian equities.
Risk of Regret
Multi-risk optimization to control for regret risk
Maximizes:
Expected Return - Risk Aversion x Standard Deviation2 -Tracking Error Aversion x Tracking Error2
Implementation Considerations
> Contract tenor
> Rebalance frequency
> Market volatility and cash flows
Summary
> There is no single hedging policy that applies to all investors
> The strategic hedging decision depends on a number of factors:
> base currency of investor
> underlying portfolio holdings
> currencies to which portfolio is exposed
> Out-of-sample tests highlight statistically significant benefits of hedging