Currency hedging and Hedge funds (Week 10).

Question 1

Hedge funds also use techniques that give them greater clout than traditional managers. First, they sell short.

Second they use leverage

Answer 1

This means selling a security that has been borrowed, hoping to replace it at a later date at a lower price

Question 2

Hedge funds

end-of-life reporting bias

Answer 2

funds stop reporting during last months prior to liquidation due to poor performance, this reates net bias in the return series. can be up to + 6%

Question 3

forward rate bias

Answer 3

forward currency rates (used for hedging) are an unbiased indicator of actual currency movements.

Question 4

insights from hedge ratio estimates

Answer 4

– High sensitivity to inputs suggests that reliable recommendations of the appropriate hedge ratio are difficult to extract from this type of statistical analysis. However, the analysis can be useful for understanding the drivers and illustrating the impact of various assumptions. It might also point towards the general direction to move with respect to the hedging decision.

Question 5

Return from CCFs broken down into

Answer 5

1. interest earned on the collateral held backing the futures position
2. insurance premium (expected future spot price - current futures price; insurance against future movements in spot price)
3. expectional variance in the future spot price of the commodity at the time the contract expires
4. rebalancing yield

Question 6

Hedge funds for the individual investor

Answer 6

• Extremely wealthy individuals or institutional vinestors would invest with 100m dollars.
• high fees
• Funds in funds available in market but individual investor, hard ot tell exact exposure in funds of funds

not approrporaite. Access is also an obstacle.

Question 7

The reason for the positive correlation between the a$ and equity markets has been largely attributed to the claim that

Answer 7

the a$ is a commodities based currency that is tied to world economic growth. australia has a much higher dependence on commodity exports than other developed countries

however, this relationship seems to have weakened somewhat over the last few years.

Question 8

considerations for setting a hedge ratio

implementation

Answer 8

Implementation issues such as the costs and management of hedging should be allowed for. Currency overlay management may be considered as an option, i.e. out-sourcing the management of hedging

Question 9

australian investor, faced with a _____ forward rate bias in its favour

Answer 9

forward rate bias

Question 10

hedged returns are a combination of

Answer 10

local asset return and the forward premium (or discount) (interest rate differential - interest rate differentials are generally small and known at any point in time)

hedged returns, at least in the short run, should be less volatile than unhedged returns.

Question 11

PPP and the forward rate bias

Answer 11

history demonstrates, and current conditions highlight, that the a$ can drift substantially away from its PPP value such that it becomes signi cantly over or undervalued. over time, the a$ may revert to its fundamental value, but this reversion can take anywhere from about three to ten year

This possibility presents difficulties for the immediate implementation of a higher strategic hedge ratio

Question 12

Drawbacks to Hedging

Answer 12

costs, peer risk and potential diversi cation benefit

Question 13

hedge fund

personnel risk

Answer 13

Losing fund manager, lose investors, money wil go with hedge fund manager

Question 14

why is hedge ratio unreliable

Answer 14

they are highly sensitive to input assumptions and hence unreliable.

Question 15

Emerging Markets

Answer 15

The emerging markets strategy used by hedge funds involves equity or fixed income investing in emerging markets around the world.

Many emerging markets do not allow short selling, nor offer viable futures or derivative products with which to hedge . Hence, emerging markets strategies often employ long only strategies

Question 16

hedged returns for both international
equities and fixed interest have been

Answer 16

higher than their unhedged counterparts

which refleect the forward currency risk premium. Foreign currency appears to provide diversifi cation benefits in a multi-asset portfolio, particularly with respect to equities. however, the negative correlations underpinning this diversi cation appear to be unstable

These statistical features of foreign currency returns mean that an optimal hedge ratio cannot be con dently calculated and hence over-reliance on a point estimate of the optimal hedge ratio is unwise

Question 17

Does investment in CCF require superior selection of active managers to be successful

Answer 17

No

Question 18

The investment return from an international asset is

Answer 18

a combination of the return on the asset, in local currency terms, as well as the return from holding foreign currency.

Question 19

hedging needs to be considered in the context of a

Answer 19

multi-asset portfolio

Question 20

Direct property funds have similar exposure to

BUT

BECAUSE

Answer 20

property market but price does not fluctate as much as listed.

Signifcant time lag for DP price to incorporate new info in property market. not traded frequently. traded among small group of investors. valuation of unit of DP is in discreet manner and much discretion from portfolio managers

Question 21

why do we do not expect the negative correlation to persist

Answer 21

past few years, the strength of the negative correlation between equities and foreign currency appears to have weakened or have moved closer to zero.

b/c the relationship between the commodities and the a$ appears to have weakened recently. This could be due to the changing nature of the australian economy from commodities to a more service based economy, which may be affecting the composition of exports

globalisation of world markets has lead to an increase in the correlations between equity markets, which may increase further in the future. in turn, this could lead to an increase in the correlation between equity markets and foreign currency.

Question 22

forward rate bias and optimal hedge ratio for australian investors

Answer 22

persistent forward rate bias seen in the australian dollar,

incorporating the forward rate bias into the analysis (along with historical covariances) produces a very high optimal hedge ratio, approaching 100%. This occurs because even conservative estimates of the forward rate bias can swamp the diversification benefits derived from holding foreign currency exposure.

The implication of these ndings is that the “theoretical” optimal strategic position for an australian investor is to be fully hedged

Question 23

Problems with performance of hedge funds

Answer 23

published performane of hedge funds is overstated due to data issues that arise from voluntary reporting of hedge fund performance.

Question 24

countries like the us, which have a zero or even negative Frb and a correlation that is closer to zero than australia, would be likely to have a

NZ

AU

Answer 24

lower h*, perhaps at around 50%.

New Zealand with a higher Frb and a similar correlation to australia would have an even more compelling case for full hedging

Question 25

Hedge Fund strategies can be broadly split into 2 categories - directional and non-directional

benefit of Non-directional strategies

Answer 25

low correlation with the market and hence can make a good diversifier for investors with market exposure

Question 26

we recommend that an investor start at 100% as a starting point

The strategic hedge ratio for that special investor should then be derived by taking into account the following:

Answer 26

1. any lack of con dence in the persistence of the forward currency risk premium or of suitably negative correlations;
2. the potential for reversion to PPP to affect expect returns materially over the investor’s time horizon;
3. the timeframe of the investor;
4. the intensity of the investor’s aversion to peer risk;
5. the intensity of the investor’s desire to minimise, or at least reduce regret; and/or
6. the inconvenience of cash ow uncertainty arising from hedging gains and losses.

Question 27

use of leverage in hedge funds can add

Answer 27

additional risk for investor’s total portfolio.

Substantial counterparty risk. If they use substantial leverage, there is substantial bankruptcy risk

Question 28

Drawbacks to Hedging

Peer Risk

Answer 28

high levels of hedging can lead to peer risk, the risk of being different.

Question 29

backfill bias

Answer 29

when a hedge fund starts reporting to a database after a period of stellar performance, its historical data is backfilled. Estimated to be 2-5% pa.

Question 30

The a$ forward rate bias has varied over time but has a positive average over the long term and also in the sub- period since the a$ oated. There are four reasons why we expect the a$ forward rate bias to persist

Answer 30

a) Risk Premium

if the forward rate bias arises because it is a risk premium rather than due to market inef ciency then it
is a structural rather than an accidental feature of the a$.

b) Insurance Premium

if the a$ is a risky currency, then it should be reasonable to expect that foreigners holding a$ assets will be willing to pay a premium to hedge this risk,
akin to an insurance premium

c) Positive GDP Differential

The interest rate differential should at least persist in the short to medium term because according to the Fisherian Golden Rule, interest rate differentials are linked to GDP differential

Question 31

Hedge funds invest in traditional asset classes, (they should not be considered a separate asset class) but do so in a way that is more flexible, responsive and opportunistic.

as a result

Answer 31

hedge funds don’t rely on general market movements for the majority of their returns. Rather their performance very much depends on the skill of the hedge fund manager

Question 32

what must be considered when implementing CCF

2. the choice of collateral and the management of the collateral

Answer 32

Australian investors not wanting to take currency exposure of CCF can consider using Australian bank bills as collateral

Question 33

considerations for setting a hedge ratio

cash flow

Answer 33

Whether the potential cash flow implications that can arise from hedging are relevant. (If loss is made on hedging, it must be settled in cash – although there will be an offsetting capital gain on asset.)

Question 34

Hedge Fund strategies can be broadly split into 2 categories - directional and non-directional

Non-directional strategies

Answer 34

focus on security selection and are not reliant on the direction of markets. A common approach managers use is to go long undervalued securities and go short overvalued securities. If the securities behave as expected, the manager earns a return from both the long and short positions.

Question 35

investment in CCF is restricted to

Answer 35

long positions only

Question 36

There are three reasons why hedging is intuitively appealing.

1. Forward rate bias

uirP does not appear to hold in practice. why? what’s the implication

Answer 36

The uirP fails because forward rates tend to over-estimate the depreciation of the spot rates of higher interest rate currencies.

The implication is that investors should have their international assets fully hedged if they expect a positive interest rate differential to persist systematically.

Question 37

Considerations to setting a hedge ratio

How the investor views the trade-offs

Answer 37

for an A$-based investor, unhedged positions have generated lower returns (via missing out on forward rate bias), but have generated a lower risk as the typical portfolio is negatively correlated with foreign currency (positively correlated with the A$).

On the other hand, there is the possibility of mean reversion in the A$. These trade-offs depend on aspects such as investor risk aversion and investment horizon

Question 38

what must be considered when implementing CCF

1. choice of index

Answer 38

each of the indices has unique approach to construction and management –> expose investors to different risks and performance

e.g. Goldman Sachs Commodity Index, Dow Jow AIG Index, Deutsche Bank Commmodity Index

Question 39

unhedged returns are a combination of

Answer 39

local asset returns + exchange rate movements

exchange rate movements are random and often large.

Question 40

How do hedge funds locate investors

Answer 40

previously established relationships, third-party marketing firms and consulting firms

Question 41

Most hedge funds charge

Answer 41

charge management fees (1-2% of assets under management ) plus a performance related fee (20% on returns above specified hurdle rate and high-water mark; not received unless fund return exceeds both of these criteria)) .

Question 42

How Much to Hedge?
the more intense the pressure of peer group risk,

Answer 42

the less attractive divergence from peer group practice becomes and since, most investors are under-hedged from a theoretical perspective, that will tend to influence the optimal hedge ratio down

Question 43

Implementing CCF

5. Currency exposure

Answer 43

commodity indices are denominated in USD, reflecting the domicile of the majority of the underlying futures contracts.

hedge the currency risk

Question 44

sources of investment returns for CCF

exceptional variance

Answer 44

exceptional variance = deviation of actual spot prices from future spot prices are very high and generate most of the volatility in realised CCF in short term

assuming commodity futures markets provide unbiased estimates of future spot prices, then deviations from actual spot prices from the expected spot prices will average to zero over time. EV is not a source of CCF ER over long term

Question 45

When constructing a hedge fund portfolio, sound manager research is vital. This is because you are investing

Answer 45

urely in the return generating skills of the hedge fund manager. The rewards for good manager selection in the hedge fund industry are many times greate

Question 46

Their timeframe and sensitivity to
peer group risk will be key. The shorter the timeframe of the investor,

Answer 46

, the smaller the quantum of forward currency premium foregone by remaining unhedged.

lower optimal hedge ratio down.

Question 47

Long/Short Equity

Answer 47

anagers employing this strategy will hold both long and short positions with a net long exposure. The objective is not to be market neutral. At all times more than 50% of the assets will be held as long positions. Managers may use futures and options to hedge

Question 48

when do hedge funds report

and do not report

Answer 48

when they are seeking investments

they cease to exist or are closed to new investments

Question 49

Which performed best since Mar’85: hedged WE or unhedged WE?

Answer 49

Since Mar’85, a fully-hedged portfolio (ZP) happened to dominate the unhedged portfolio (UP), generating higher returns for similar SD.

However, this is specific to this period, and need not always be the case. Again, it is possible that the ex post optimal hedge ratio over any particular period is neither fully hedged nor fully-unhedged.

Question 50

successfully implementing a hedge fund strategy is difficult because

As a result, most investors look to

Answer 50

multi manager hedge fund products. These multi manager hedge funds provide diversification across managers as well as strategies, access to a higher standard of research, access to top tier managers, ongoing monitoring and a higher level of liquidity

Question 51

Drawbacks to Hedging

Peer Risk

how to avoid peer risk?

Answer 51

investors can avoid peer risk by being reasonably close to the hedge ratio adopted by the average asset allocation of their relevant peers across all types of super funds in australia, the average hedge ratio is about 35%.

Question 52

successfully implementing a hedge fund strategy is difficult because

Answer 52

Its “newness”, relatively unregulated structure, tradition of non-disclosure, absence of reporting standards, and reliance on unconventional strategies

Question 53

The hedge fund industry is subject to much less regulation than the traditional investment management industry.

Answer 53

The legal structures of many hedge funds are minimally regulated and investors are often confronted by a lack of transparency

Hedge Fund managers are often reluctant to give out their security holdings as they see it as proprietary information about their strategies.

Question 54

impact of correlation between foreign currency and Australian and international equities

Answer 54

Since float of $A, correlation has been negative

correlations that are less negative reduce the diversification benefit of foreign currency and hence support a higher level of hedging

Question 55

The range of returns and risk amongst hedge fund managers is

Answer 55

high; varies widely between managers

Question 56

Hedge funds and survivorship bias

Answer 56

hedge funds disclosure is not compulsory. Portfolio manager will not report performance. This is not regulated. Decides to report to hedge fund database,

Cambridge association, they have much discretion of when to report and how much to report their performance

Question 57

Including CCF in a diversified portfolio

Answer 57

low correlation with equities and bonds. reduce the std with little impact on mean returns

portfolio without CCF vs portfolios including 10% allocation to CCF using the DAJIG and GSCI indices

Question 58

sources of investment returns for CCF

rebalancing yield

Answer 58

act of continually rebalancing assets leads to buy low and sell high. impact is higher for assets with lower correlations e.g. CCF

Question 59

for active managers to consistently generate alpha

Answer 59

they must be able to consistently exploit market inefficiencies

Question 60

Do hedge funds offer liquidity?

Answer 60

investors are required to invest their money for longer periods

Question 61

How substantial is the benchmark-relative risk arising from currency hedging decisions? (see ‘Differences’)

Answer 61

The tracking error relative to the benchmark portfolio (BP) is 1.9% pa for the fully-hedged portfolio (ZP) and fully-unhedged portfolio (UP) portfolios. This level of tracking error is meaningful. (The standard deviation of returns across Australian growth super funds is roughly 2% pa

Question 62

hedge fund attribution

Reporting hedge funds have generated

Answer 62

3% alpha, 4.6% beta (driven by general market movement, not skills of hedge fund) excess return 3.4% distributed to hedge fund managers

Total return of hedge fund is 11%.

Question 63

what must be considered when implementing CCF

1. choice of index

When may GSCI be used?

Answer 63

Investors comfortable with higher volatiity resulting from energy exposure

no restrictions on the max exposure to any commodity or sector.

largest exposure to one sector within this index is to energy (most volatile commodity contracts - tied directly to global economic activity and higher ER in long term to commesurate with its risk)

Question 64

the strategic currency hedge ratio needs to be determined taking account the

Answer 64

circumstances and preferences of the investor, such as time frame, peer
risk and regret.

Question 65

Examine the mean and standard deviation for the cs proxy series, as well as its correlation with ZP. What does it tell you about the effect of adding exposure to foreign currency to an Australian portfolio?

Risk:

Answer 65

The negative correlation of cs with the zero-exposure benchmark portfolio (-0.21 since Mar’85) suggests that some degree of foreign currency exposure will reduce portfolio risk.

While a hedge ratio of less than 100% reduces risk, the minimum variance hedge ratio (found by setting E[cs] = 0) depends on the inputs. The ex post minimum variance hedge ratio was 46% since Mar’85

Question 66

There are three reasons why hedging is intuitively appealing.

Capturing equity and debt market risk premia

Answer 66

Full hedging delivers the MrP, while being unhedged delivers additional risk in the form of currency surprise.

The difference between unhedged and hedged returns is the currency surprise, de ned as the difference between the foreign currency return (Fc) and the interest rate differential (irD)

Fc & irD have tended to come together over time, which is likely to
be driven by the a$ mean reverting to PPP.

Question 67

Hedge Fund strategies can be broadly split into 2 categories - directional and non-directional

directional

Answer 67

Directional strategies are market timing strategies. The manager takes long and short positions in different markets and uses leverage to magnify their exposures.

These strategies involve higher risk because they hinge on the managers making the correct calls about the direction of particular markets

Question 68

e. The forward foreign currency rates for an investor are determined by the

Answer 68

differentials between that investor’s home interest rate with those of the rest of the world. This principle is known as covered interest rate parity

Question 69

hedge fund attribution

alpha generated is shared between

Answer 69

Hedge fund managers and investors are sharing alpha. Hedge fund managers took larger part of excess return.

Question 70

Drawbacks to Hedging

Hedging Costs

Answer 70

costs incurred in implementing a hedging program can act to reduce hedged returns

BUT low in australian investors passive hedging is estimated to cost about 0.06% per annum. australian investors typically face a forward discount on the a$, and thus they receive a bene t from hedging.

some other countries, particularly the us, the forward premium is also considered to be a hedging cost.

Question 71

Hedge funds

survivorship bias

Answer 71

database includes only currently existing funds and removes funds that have closed or no longer report. leaving successful funds in the database creating an updward return bias.

Question 72

what must be considered when implementing CCF

2. replicating the index returns

approaches taken

Answer 72

apparoaches taken to gain a passive commodity futures exposure

1. long position in individual futures contract
2. long position in index futures contract
3. total return swap

Question 73

Commodity returns and equities

relationshipbroadl

Answer 73

broadly comparable volatility but have a low correlation with equities

Question 74

There are three reasons why hedging is intuitively appealing.

1. Free lunch

does it hold in Australia?

Answer 74

First assumption: There is strong evidence that it does not hold for the a$

Second assumption: depends on the correlation of
the foreign currency with not just the international assets, but also the other assets in the portfolio. For australian investors there appears to be empirical evidence of a signi cant negative correlation between foreign currency and both australian and international equities. The question is whether this correlation is suf ciently negative to produce diversi cation bene

Question 75

what must be considered when implementing CCF

Answer 75

1. choice of index
2. the choice of collateral and the management of the collateral
3. approach to replicating the index returns
4. Actiev or passive management
5. management of currency exposure
6. costs associated with investing

Question 76

Convertible Arbitrage

Answer 76

This strategy aims to profit from mispricing opportunities within convertible bonds and other hybrid securities.

These securities are a combination of various instruments and the price of the parcel as a whole may be different to the sum of the prices of the component parts. If this is the case there exists an opportunity to buy (sell) the parcel and sell (buy) the various component parts to lock in a profit.

Question 77

The lower the portfolio risk

Answer 77

the higher the optimal, even at lower levels of Frb and correlation

Question 78

what must be considered when implementing CCF

1. choice of index

When may DJAIG and DBLCI be used?

Answer 78

Investor wanting less volatile streams of CCF returns

DJAIG: max of 33% of the index can be exposed to any one sector

DBLCI: largest exposure to any one sector in this index is energy at 55%

Question 79

Hedge Fund

Part of total return can be generated by

Answer 79

general market movement

Some can be security selection skills of manager

Question 80

the higher the portfolio risk,

Answer 80

the greater the sensitivity of the optimal hedge ratio to small changes in the inputs

Question 81

There are three reasons why hedging is intuitively appealing.

1. Free lunch

Answer 81

currency hedging producing a substantial risk reduction with no loss of expected returns.

The second assumption depends on the correlation of
the foreign currency with not just the international assets, but also the other assets in the portfolio.

Question 82

hedged returns, at least
in the short run, should be less volatile than unhedged returns. however, this does not imply that hedging is always preferable to not hedging: we must consider

the possibility of

Answer 82

eriving a diversi cation bene t from holding foreign currency in a multi-asset portfolio.
This can occur when the correlation between foreign currency and portfolio returns is signi cantly negative.

Question 83

There are three reasons why hedging is intuitively appealing.

1. Forward rate bias

Answer 83

The proposition that the expected change in the spot currency rate should equal the interest rate differentialis known as uncovered interest rate parity (uirP). The implication of the uirP is that forward currency rates are unbiased predictors of actual currency movements, which is referred to as speculative ef ciency

uirP does not appear to hold in practice.

Question 84

Implementing CCF Portfolio

4. choice of theseactive management

Answer 84

these products attempt to add value by taking positions different from the benchmark (passive management = replicating the index)

Question 85

currency surprise obviously creates risks,

Answer 85

investment risk, peer risk and timing risk.

investment risk is the risk/return characteristics of hedged versus unhedged returns, which is the focus of this paper.

The amplitude of the uctuations in currency surprise highlights the peer risk involved with being at the extremes of either fully hedged or fully unhedged.

fund members face timing risk when investing in unhedged products. even if in
the long run PPP holds and thus there is little difference between hedged and unhedged returns, investors still face the risk of entering and exiting an unhedged fund
at an inopportune time; for example if the a$ happens
to appreciate over the term of their investment.

Question 86

Considerations to setting a hedge ratio

Why does Return need to be considered

Answer 86

Return that is expected from currency exposure. Aspects to consider might include:

• Forward rate bias – traditionally has generated higher returns to hedging over long run
• Mean reversion potential over long term – A$ is currently above PPP
• Tendency towards momentum in short run (known to occur in currency markets as well)
• Any views held by the investor about the currency outlook

Question 87

empirical evidence is supportive of hedging

but overall

Answer 87

both hedged equities and fixed interest have outperformed their unhedged counterparts

Question 88

Hedge funds

back-fill bias

Answer 88

when a fund is added to a database, its return history is also typically included, or backfilled.

Funds with successful operating performance are more likely to be added to a database, the return is biased upward. A fund that has posted poor returns does note report, and its unsucessful history is not added to the database

Question 89

Considerations to setting a hedge ratio

Why does risk need to be considered

Answer 89

Type of risk that matters under the fund’s objectives, for example:

• Portfolio volatility – focus on correlation with ZP (negative for Australian investors, hence points to diversification benefits), although relative standard deviation also has an influence
• Peer risk – focus on hedging position of peer group, and TE arising from deviations
• Regret – 50% hedged is the minimum risk position

Question 90

Drawbacks of currency hedging

The other reason unhedged currency exposure may provide diversi cation bene ts to a multi-asset portfolio
is

Answer 90

the sensitivity of the a$ to major economic shocks
such as the global stock market crash of 1987 and the russian debt crisis.

appears that foreign currency measured against the
a$ can provide an australian investor with portfolio diversi cation when it is needed most, for example during times of crisis

Question 91

optimal hedge ratio

what can have a major impact

Answer 91

small changes to the input values (expected return, risk or correlation)

Question 92

The forward foreign currency rates for an investor are determined by the differentials between that investor’s home interest rate with those of the rest of the world. This principle is known as covered interest rate parity

for investors in australia, New Zealand and the uK,

Answer 92

for investors in australia, New Zealand and the uK, where interest rates have been higher relative to other developed countries; those currencies have typically sold
at a forward discount. hence, australian investors have been paid to hedge foreign currency, as they receive a positive interest rate differential.