Reading 18 Currency Management: An Introduction

Question 1

Spot Markets

Answer 1

• Most people think only of spot transactions when they think of the foreign exchange market, but in fact the spot market accounts for less than 40% of the average daily turnover in currencies.1 Although cross-border business may be transacted in the spot market (making and receiving foreign currency payments), the risk management of these flows takes place in FX derivatives markets (i.e., using forwards, FX swaps, and currency options).
• How the professional FX market quotes exchange rates - generally, there is a hierarchy as to which currency will be quoted as the base currency in any given P/B currency pair:

1. Currency pairs involving the EUR will use the EUR as the base currency (for example, GBP/EUR).
2. Currency pairs involving the GBP, other than those involving the EUR, will use the GBP as the base currency (for example, CHF/GBP).
3. Currency pairs involving either the AUD or NZD, other than those involving either the EUR or GBP, will use these currencies as the base currency (for example, USD/AUD and NZD/AUD). The market convention between these two currencies is for a NZD/AUD quote.
4. All other currency quotes involving the USD will use USD as the base currency (for example, MXN/USD).

• Another convention used in professional FX markets is that most spot currency quotes are priced out to four decimal places: for example, a typical USD/EUR quote would be 1.3500 and not 1.35. The price point at the fourth decimal place is commonly referred to as a “pip.”Professional FX traders also refer to what is called the “big figure” or the “handle,” which is the integer to the left side of the decimal place as well as the first two decimal places of the quote. For example, for a USD/EUR quote of 1.3568, 1.35 is the handle and there are 68 pips.
• There are exceptions to this four decimal place rule. First, forward quotes—­discussed later—­will often be quoted out to five and sometimes six decimal places. Second, because of the relative magnitude of some currency values, some currency quotes will only be quoted out to two decimal places. For example, because it takes many Japanese yen to buy one US dollar, the typical spot quote for JPY/USD is priced out to only two decimal places (for example, 86.35 and not 86.3500).
• The spot exchange rate is usually for settlement on the second business day after the trade date, referred to as T + 2 settlement.The bid price is the price, defined in terms of the price currency, at which the counterparty providing a two-sided price quote is willing to buy one unit of the base currency. Similarly, offer price is the price, in terms of the price currency, at which that counterparty is willing to sell one unit of the base currency. For example, given a price request from a client, a dealer might quote a two-sided price on the spot USD/EUR exchange rate of 1.3648/1.3652.

Question 2

Forward Markets

Answer 2

• Forward contracts are agreements to exchange one currency for another on a future date at an exchange rate agreed on today. In contrast to spot rates, forward contracts are any exchange rate transactions that occur with settlement longer than the usual T + 2 settlement for spot delivery.
• In professional FX markets, forward exchange rates are typically quoted in terms of “points.” The points on a forward rate quote are simply the difference between the forward exchange rate quote and the spot exchange rate quote; that is, the forward premium or discount, with the points scaled so that they can be related to the last decimal place in the spot quote. Forward points are adjustments to the spot price of the base currency, using our standard price/base (P/B) currency notation.
• Although there is no cash flow on a forward contract until settlement date, it is often useful to do a mark-to-market valuation on a forward position before then to (1) judge the effectiveness of a hedge based on forward contracts (i.e., by comparing the change in the mark-to-market of the underlying asset with the change in the mark-to-market of the forward), and (2) to measure the profitability of speculative currency positions at points before contract maturity.
• As with other financial instruments, the mark-to-market value of forward contracts reflects the profit (or loss) that would be realized from closing out the position at current market prices. To close out a forward position, it must be offset with an equal and opposite forward position using the spot exchange rate and forward points available in the market when the offsetting position is created. When a forward contract is initiated, the forward rate is such that no cash changes hands (i.e., the mark-to-market value of the contract at initiation is zero). From that moment onward, however, the mark-to-market value of the forward contract will change as the spot exchange rate changes as well as when interest rates change in either of the two currencies.
• The all-in forward rate is simply the sum of the spot rate and the forward points, appropriately scaled to size.

Question 3

The process for marking-to-market a forward position

Answer 3

Consider an example.

Suppose that a market participant bought GBP10,000,000 for delivery against the AUD in six months at an “all-in” forward rate of 1.6100 AUD/GBP. (The all-in forward rate is simply the sum of the spot rate and the forward points, appropriately scaled to size.) Three months later, the market participant wants to close out this forward contract. To do that would require selling GBP10,000,000 three months forward using the AUD/GBP spot exchange rate and forward points in effect at that time. Assume the bid–offer for spot and forward points three months prior to the settlement date are as follows:

Spot rate (AUD/GBP) 1.6210/1.6215
Three-month points 130/140

To sell GBP (the base currency in the AUD/GBP quote) means calculating the bid side of the market. Hence, the appropriate all-in three-month forward rate to use is

1.6210 + 130/10,000 = 1.6340

Thus, the market participant originally bought GBP10,000,000 at an AUD/GBP rate of 1.6100 and subsequently sold them at a rate of 1.6340. These GBP amounts will net to zero at settlement date (GBP10 million both bought and sold), but the AUD amounts will not net to zero because the forward rate has changed. The AUD cash flow at settlement date will be equal to

(1.6340 – 1.6100) × 10,000,000 = AUD240,000

This amount is a cash inflow because the market participant was long the GBP with the original forward position and the GBP subsequently appreciated (the AUD/GBP rate increased).

This cash flow is paid at settlement day, which is still three months away. To calculate the mark-to-market value on the dealer’s position, this cash flow must be discounted to the present. The present value of this amount is found by discounting the settlement day cash flow by the three-month discount rate. Because it is an AUD amount, the three-month AUD discount rate is used. If Libor is used and the three-month AUD Libor is 4.80% (annualized), the present value of this future AUD cash flow is then

AUD 240,000 / (1+0.048[90/360])=AUD 237,154

This is the mark-to-market value of the original long GBP10 million six-month forward contract when it is closed out three months prior to settlement.

The process for marking-to-market a forward position is relatively straightforward:

1. Create an equal and offsetting forward position to the original forward position. (In the example earlier, the market participant is long GBP10 million forward, so the offsetting forward contract would be to sell GBP10 million.)
2. Determine the appropriate all-in forward rate for this new, offsetting forward position. If the base currency of the exchange rate quote is being sold (bought), then use the bid (offer) side of the market.
3. Calculate the cash flow at settlement day. This calculation will be based on the original contract size times the difference between the original forward rate and the rate calculated in Step 2. If the currency the market participant was originally long (short) subsequently appreciated (depreciated), then there will be a cash inflow. Otherwise, there will be a cash outflow. (In the earlier example, the market participant was long the GBP and it subsequently appreciated; this appreciation led to a cash inflow at the settlement day.)
4. Calculate the present value of this cash flow at the future settlement date. The currency of the cash flow and the discount rate must match (In the example earlier, the cash flow at the settlement date is in AUD, so an AUD Libor rate is used to calculate the present value.)

Question 4

FX Swap Markets

Answer 4

• An FX swap transaction consists of offsetting and simultaneous spot and forward transactions, in which the base currency is being bought (sold) spot and sold (bought) forward. These two transactions are often referred to as the “legs” of the swap. The two legs of the swap can either be of equal size (a “matched” swap) or one can be larger than the other (a “mismatched” swap). FX swaps are distinct from currency swaps. Similar to currency swaps, FX swaps involve an exchange of principal amounts in different currencies at swap initiation that is reversed at swap maturity. Unlike currency swaps, FX swaps have no interim interest payments and are nearly always of much shorter term than currency swaps.
• FX swaps are important for managing currency risk because they are used to “roll” forward contracts forward as they mature.
• A hedge ratio is the ratio of the nominal value of the derivatives contract used as a hedge to the market value of the hedged asset.

Question 5

Currency Options

Answer 5

• “Exotic” options have a variety of features that make them exceptionally flexible risk management tools, compared with vanilla options.
• Although daily turnover in FX options market is small in relative terms compared with the overall daily flow in global spot currency markets, because the overall currency market is so large, the absolute size of the FX options market is still very considerable.

Question 6

Return Decomposition

Answer 6

• A domestic asset is an asset that trades in the investor’s domestic currency (or home currency).
• Foreign assets are assets denominated in currencies other than the investor’s home currency.
• The return on a foreign asset will be affected by exchange rate movements in the home currency against the** foreign currency**.
• The return of the foreign asset measured in foreign-currency terms is known as the** foreign-currency return**.
• The domestic-currency return on a foreign asset will reflect both the foreign-currency return on that asset as well as percentage movements in the spot exchange rate between the home and foreign currencies. The domestic-currency return is multiplicative with respect to these two factors:

R_DC = (1 + R_FC)(1 + R_FX) – 1

where R_DC is the domestic-currency return (in percent), R_FC is the foreign-currency return, and R_FX is the percentage change of the foreign currency against the domestic currency. Formula for domestic-currency returns (R_DC) requires that the domestic currency be the price currency

• Equation above hides a subtlety that must be recognized. The term R_FX is defined as the percentage change in the foreign currency against the domestic currency. However, this change is not always the same thing as the percentage change in the spot rate using market standard P/B quotes.
• This distinction is important because which currency is considered the domestic currency and whether it is either the base or the price currency in the market standard P/B quote will lead to completely different mathematical results. This happens in two ways. First, it determines thesign, or direction, of the exchange rate appreciation.
• Another way in which quoting conventions affect mathematical results involves the fact that the foreign exchange return, R_FX in Equation above, is calculated with the investor’s domestic currency as the price currency. Even if one gets the sign, or direction, of change right, it is not necessarily the case that one can simply “flip the sign” of the percentage change in market standard P/B to get the right answer.
• To be accurate, the foreign exchange calculation in Equation above must be quoted so that the “domestic” currency is always the price currency. One must be careful when using quote conventions and make adjustments as necessary to calculate the domestic-currency return properly.
• More generally, the domestic-currency return on a portfolio of multiple foreign assets will be equal to:

R_DC=∑_i=1ⁿω_i(1+R_FC,i)(1+R_FX,i)−1

where R_FC,i is the foreign-currency return on the i-th foreign asset, R_FX,i is the appreciation of the i-th foreign currency against the domestic currency, and ω_i are the portfolio weights of the foreign-currency assets (defined as the percentage of the aggregate domestic-currency value of the portfolio) and ∑_i=1ⁿω_i = 1. (Note that if short selling is allowed in the portfolio, some of the ω_i can be less than zero.) Again, it is important that the exchange rate notation in this expression (used to calculate R_FX,i) must be consistently defined with the domestic currency as the price currency.

Question 7

Volatility Decomposition

Answer 7

σ²(R_DC) ≈ σ²(R_FC) + σ²(R_FX) + 2σ(R_FC)σ(R_FX)ρ(R_FC,R_FX)

σ²(ω₁R₁+ω₂R₂)≈ω²₁σ²(R₁)+ω²₂σ²(R₂)+2ω₁ω₂σ(R₁)σ(R₂)ρ(R₁,R₂)

where R_i is the domestic-currency return of the i-th foreign-currency asset.

Question 8

Currency Management: Strategic Decisions

Answer 8

• One camp of thought holds that in the long run currency effects cancel out to zero as exchange rates revert to historical means or their fundamental values. Moreover, an efficient currency market is a zero-sum game (currency “A” cannot appreciate against currency “B” without currency “B” depreciating against currency “A”), so there should not be any long-run gains overall to speculating in currencies, especially after netting out management and transaction costs. Therefore, both currency hedging and actively trading currencies represent a cost to a portfolio with little prospect of consistently positive active returns.
• At the other extreme, another camp of thought notes that currency movements can have a dramatic impact on short-run returns and return volatility and holds that there are pricing inefficiencies in currency markets.

Question 9

The Investment Policy Statement

Answer 9

The IPS sets the guiding parameters within which more specific portfolio management policies are set, including the target asset mix; whether and to what extent leverage, short positions, and derivatives can be used; and how actively the portfolio will be allowed to trade its various risk exposures.

For most portfolios, currency management can be considered a sub-set of these more specific portfolio management policies within the IPS. The currency risk management policy will usually address such issues as the

• target proportion of currency exposure to be passively hedged;
• latitude for active currency management around this target;
• frequency of hedge rebalancing;
• currency hedge performance benchmark to be used; and
• hedging tools permitted (types of forward and option contracts, etc.).

Question 10

The Portfolio Optimization Problem

Answer 10

Many portfolio managers handle asset allocation with currency risk as a two-step process:

1. portfolio optimization over fully hedged returns; and
2. selection of active currency exposure, if any.

The portfolio manager will choose the exposures to the foreign-currency assets first, and then decide on the appropriate currency exposures afterward (i.e., decide whether to relax the full currency hedge). These decisions are made to simplify the portfolio construction process.

Question 11

Choice of Currency Exposures: Diversification Considerations

Answer 11

• Many investment practitioners believe that in the long run, adding unhedged foreign-currency exposure to a portfolio does not affect expected long-run portfolio returns; hence in the long run, it would not matter if the portfolio was hedged.
• an investor (IPS) with a very long investment horizon and few immediate liquidity needs—which could potentially require the liquidation of foreign-currency assets at disadvantageous exchange rates—might choose to forgo currency hedging and its associated costs. Logically, this would require a portfolio benchmark index that is also unhedged against currency risk.
• Diversification considerations will also depend on the asset composition of the foreign-currency asset portfolio. The reason is because the foreign-currency asset returns (R_FC) of different asset classes have different correlation patterns with foreign-currency returns (R_FX).
• It is often asserted that the correlation between foreign-currency returns and foreign-currency asset returns tends to be greater for fixed-income portfolios than for equity portfolios. This assertion makes intuitive sense: both bonds and currencies react strongly to movements in interest rates, whereas equities respond more to expected earnings. As a result, the implication is that currency exposures provide little diversification benefit to fixed-income portfolios and that the currency risk should be hedged.
• The hedge ratio is defined as the ratio of the nominal value of the hedge to the market value of the underlying.
• Optimal hedge ratio also seems to depend on market conditions and longer-term trends in currency pairs.
• Actual hedge ratios vary widely in practice among different investors. Nonetheless, it is still more likely to see currency hedging for fixed-income portfolios rather than equity portfolios, although actual hedge ratios will often vary between individual managers.

Question 12

Passive Hedging

Answer 12

• Passive hedging is a rules-based approach that removes almost all discretion from the portfolio manager, regardless of the manager’s market opinion on future movements in exchange rates or other financial prices.
• Active currency management—taking positional views on future exchange rate movements—is viewed as being incapable of consistently adding incremental return to the portfolio.

Question 13

Discretionary Hedging

Answer 13

This approach is similar to passive hedging in that there is a “neutral” benchmark portfolio against which actual portfolio performance will be measured. However, in contrast to a strictly rules-based approach, the portfolio manager now has some limited discretion on how far to allow actual portfolio risk exposures to vary from the neutral position. Usually this discretion is defined in terms of percentage of foreign-currency market value (the portfolio’s currency exposures are allowed to vary plus or minus x% from the benchmark).

Question 14

Choice of Currency Exposures: Cost Considerations

Answer 14

Optimal hedging decisions will need to balance the benefits of hedging against these costs.

Hedging costs come mainly in two forms: trading costs and opportunity costs.

The most immediate costs of hedging involve trading expenses, and these come in several forms:

• Trading involves dealing on the bid–offer spread offered by banks. Their profit margin is based on these spreads, and the more the client trades and “pays away the spread,” the more profit is generated by the dealer. Maintaining a 100% hedge and rebalancing frequently with every minor change in market conditions would be expensive.
• Some hedges involve currency options; a long position in currency options requires the payment of up-front premiums. If the options expire out of the money (OTM), this cost is unrecoverable.
• Although forward contracts do not require the payment of up-front premiums, they do eventually mature and have to be “rolled” forward with an FX swap transaction to maintain the hedge. Rolling hedges will typically generate cash inflows or outflows. These cash flows will have to be monitored, and as necessary, cash will have to be raised to settle hedging transactions. In other words, even though the currency hedge may reduce the volatility of the domestic mark-to-market value of the foreign-currency asset portfolio, it will typicallyincrease the volatility in the organization’s cash accounts. Managing these cash flow costs can accumulate to become a significant portion of the portfolio’s value, and they become more expensive (for cash outflows) the higher interest rates go.
• One of the most important trading costs is the need to maintain an administrative infrastructure for trading. Front-, middle-, and back-office operations will have to be set up, staffed with trained personnel, and provided with specialized technology systems. Settlement of foreign exchange transactions in a variety of currencies means having to maintain cash accounts in these currencies to make and receive these foreign-currency payments. Together all of these various overhead costs can form a significant portion of the overall costs of currency trading.

A second form of costs associated with hedging are the opportunity cost of the hedge. To be 100% hedged is to forgo any possibility of favorable currency rate moves.

• Opportunity costs lead to another motivation for having a strategic hedge ratio of less than 100%: regret minimization.
• Confronted with this ex ante dilemma of whether to hedge, many portfolio managers decide simply to “split the difference” and have a 50% hedge ratio (or some other rule-of-thumb number).
• The portfolio manager (and IPS) would likely not try to hedge every minor, daily change in exchange rates or asset values, but only the larger adverse movements that can materially affect the overall domestic-currency returns (R_DC) of the foreign-currency asset portfolio. The portfolio manager will need to balance the benefits and costs of hedging in determining both strategic positioning of the portfolio as well as any latitude for active currency management. However, around whatever strategic positioning decision taken by the IPS in terms of the benchmark level of currency exposure, hedging cost considerations alone will often dictate arange of permissible exposures instead of a single point. (This discretionary range is similar to the deductible in an insurance policy.)

Question 15

Active Currency Management

Answer 15

• For all forms of active management (i.e., having the discretion to express directional market views), there is no allowance for unlimited speculation; there are risk management systems in place for even the most speculative investment vehicles, such as hedge funds. These controls are designed to prevent traders from taking unusually large currency exposures and risking the solvency of the firm or fund.
• The primary duty of the discretionary hedger is to protect the portfolio from currency risk. As a secondary goal, within limited bounds, there is some scope for directional opinion in an attempt to enhance overall portfolio returns. In contrast, the active currency manager is supposed to take currency risks and manage them for profit. The primary goal is to add alpha to the portfolio through successful trading.

Question 16

Currency Overlay

Answer 16

Active currency management is often associated with what are called** currency overlay programs**, although this term is used differently by different sources.

• In the most limited sense of the term, currency overlay simply means that the portfolio manager has outsourced managing currency exposures to a firm specializing in FX management.
• A broader view of currency overlay allows the externally hired currency overlay manager to take directional views on future currency movements (again, with the caveat that these be kept within predefined bounds).
• In contrast, the concept of foreign exchange as an asset class does not restrict the currency overlay manager, who is free to take FX exposures in any currency pair where there is value-added to be harvested, regardless of the underlying portfolio. In this sense, the currency overlay manager is very similar to an FX-based hedge fund.

Adding this form of currency overlay to the portfolio (FX as an asset class) is similar in principle to adding any type of alternative asset class, such as private equity funds or farmland. In each case, the goal is the search for alpha. But to be most effective in adding value to the portfolio, the currency overlay program should add incremental returns (alpha) and/or greater diversification opportunities to improve the portfolio’s risk–return profile. To do this, the currency alpha mandate should have minimum correlation with both the major asset classes and the other alpha sources in the portfolio.

Within the overall portfolio allocation to “currency as an alternative asset class”, it may be beneficial to diversify across a range of active management styles, either by engaging several currency overlay managers with different styles or by applying a fund-of-funds approach, in which the hiring and management of individual currency overlay managers is delegated to a specialized external investment vehicle.

Question 17

Formulating a Client-Appropriate Currency Management Program

Answer 17

Generally speaking, the strategic currency positioning of the portfolio, as encoded in the IPS, should be biased toward a more-fully hedged currency management program the more:

• short term the investment objectives of the portfolio;
• risk averse the beneficial owners of the portfolio are (and impervious to ex post regret over missed opportunities);
• immediate the income and/or liquidity needs of the portfolio;
• fixed-income assets are held in a foreign-currency portfolio;
• cheaply a hedging program can be implemented;
• volatile (i.e., risky) financial markets are; and
• skeptical the beneficial owners and/or management oversight committee are of the expected benefits of active currency management.

Question 18

Currency Management: Tactical Decisions

Answer 18

There is no simple formula, model, or approach that will allow market participants to precisely forecast exchange rates (or any other financial prices) or to be able to be confident that any trading decision will be profitable.

Question 19

Active Currency Management Based on Economic Fundamentals

Answer 19

The simple economic model described in this section is based on the assumption that in the long run, the real exchange rate will converge to its “fair value,” but short- to medium-term factors will shape the convergence path to this equilibrium.

Over shorter time frames, movements in real exchange rates will also reflect movements in the real interest rate differential between countries.

The base currency’s real exchange rate should appreciate if there is an upward movement in:

• its long-run equilibrium real exchange rate;
• either its real or nominal interest rates, which should attract foreign capital;
• expected foreign inflation, which should cause the foreign currency to depreciate; and
• the foreign risk premium, which should make foreign assets less attractive compared with the base currency nation’s domestic assets.

The real exchange rate should also increase if it is currently below its long-term equilibrium value.

(Institute 21)

Institute, CFA. 2015 CFA Level III Volume 4 Fixed Income and Equity Portfolio Management. Wiley Global Finance, 2014-07-14. VitalBook file.

Приведенная цитата является инструкцией. Необходимо проверять точность каждой цитаты перед использованием.

Question 20

Active Currency Management Based on Technical Analysis

Answer 20

• First, market technicians believe that in a liquid, freely traded market the historical price data can be helpful in projecting future price movements.
• Second, market technicians believe that historical patterns in the price data have a tendency to repeat, and that this repetition provides profitable trade opportunities. These price patterns repeat because market prices reflect human behavior and human beings have a tendency to react in similar ways to similar situations, even if this repetitive behavior is not always fully rational.
• Third, technical analysis does not attempt to determine where market prices should trade (fair value, as in fundamental analysis) but where they will trade.
• Technical analysis tries to identify when markets have become overbought or oversold, meaning that they have trended too far in one direction and are vulnerable to a trend reversal, or correction. Technical analysis also tries to identify what are called support levels and resistance levels, either within ongoing price trends or at their extremities (i.e., turning points).
• Once these price points are breached, the price action can be expected to accelerate as stops are triggered. (Stops, in this sense, refer to stop-loss orders, in which traders leave resting bids or offers away from the current market price to be filled if the market reaches those levels. A stop-loss order is triggered when the price action has gone against a trader’s position, and it gets the trader out of that position to limit further losses.)

Question 21

Active Currency Management Based on the Carry Trade

Answer 21

• The carry trade is a trading strategy of borrowing in low-yield currencies and investing in high-yield currencies. If technical analysis is based on ignoring economic fundamentals, then the carry trade is based on exploiting a well-recognized violation of one of the international parity conditions often used to describe these economic fundamentals: uncovered interest rate parity.
• Uncovered interest rate parity asserts that, on a longer-term average, the return on an unhedged foreign-currency asset investment will be the same as a domestic-currency investment.
• According to the uncovered interest rate parity theorem, it is this offset between:
  
  • (1) the yield advantage and
  • (2) the currency depreciation that equates, on average, the unhedged currency returns.
• In reality, the historical data show that there are persistent deviations from uncovered interest rate parity in FX markets, at least in the short to medium term. Indeed, high-yield countries often see their currencies appreciate, not depreciate, for extended periods of time.
• This persistent violation of uncovered interest rate parity described by the carry trade is often referred to as the** forward rate bias. An implication of uncovered interest rate parity is that the forward rate should be an unbiased predictor of future spot rates. The historical data, however, show that the forward rate is not the center of the distribution for future spot rates; in fact, it is a biased predictor. Trading the forward rate bias involves buying currencies selling at a forward discount, and selling currencies trading at a forward premium. This makes intuitive sense: It is desirable to buy low and sell high.
• When the base currency has a lower interest rate than the price currency (i.e., the right side of the equality is positive) the base currency will trade at a forward premium (the left side of the equality is positive). That is, being low-yield currency and trading at a forward premium is synonymous. Similarly, being a high-yield currency means trading at a forward discount. Borrowing in the low-yield currency and investing in the high-yield currency (the carry trade) is hence equivalent to selling currencies that have a forward premium and buying currencies that have a forward discount (trading the forward rate bias).
• Return distribution for the carry trade has a pronounced negative skew. This negative skew derives from the fact that the funding currencies of the carry trade (the low-yield currencies in which borrowing occurs) are typically the safe haven currencies, such as the USD, CHF, and JPY. In contrast, the** investment currencies** (the high-yielding currencies) are typically currencies perceived to be higher risk, such as several emerging market currencies.

Question 22

Active Currency Management Based on Volatility Trading

Answer 22

The two most important Greeks that we will consider here are the following:

• Delta: The sensitivity of the option premium to a small change in the price of the underlying of the option, typically a financial asset. This sensitivity is an indication of price risk.
• Vega: The sensitivity of the option premium to a small change in implied volatility. This sensitivity is an indication of* volatility* risk.

The most important concept to grasp in terms of volatility trading is that the use of options allows the trader, through a variety of trading strategies, to *unbundle *and isolate all of the various risk factors (the Greeks) and trade them separately. Once an initial option position is taken (either long or short), the trader has exposure to all of the various Greeks/risk factors. The unwanted risk exposures, however, can then be hedged away, leaving *only *the desired risk exposure to express that specific directional view.

**Delta hedging **is the act of hedging away the option position’s exposure to delta, the price risk of the underlying (the FX spot rate, in this case). Spot, by definition, has a delta of one, and no exposure to any other of the Greeks; forward contracts are highly correlated with the spot rate. The size of the delta hedge is equal to the option’s delta times the nominal size of the contract.

By engaging in volatility trading, the trader is expressing a view about the future volatility of exchange rates but not their direction (the delta hedge set the net delta of the position to zero).

One simple option strategy that implements a volatility trade is a** straddle**, which is a combination of both an at-the-money (ATM) put and an ATM call.

A similar option structure is a strangle position for which a long position is buying out-of-the-money (OTM) puts and calls with the same expiry date and the same degree of being out of the money (we elaborate more on this subject later. Because OTM options are being bought, the cost of the position is cheaper—but conversely, it also does not pay off until the spot rate passes the OTM strike levels. As a result, the risk–reward for a strangle is more moderate than that for a straddle.

The interesting thing to note is that by using delta-neutral trading strategies, volatility is turned into a product that can be actively traded like any other financial product or asset class, such as equities, commodities, fixed-income products, and so on.

Just as currency overlay programs manage the portfolio’s exposure to currency delta (movements in spot exchange rates), volatility overlay programs manage the portfolio’s exposure to currency vega.

Deltas for puts can range from a minimum of –1 to a maximum of 0, with a delta of –0.5 being the point at which the put option is ATM; OTM puts have deltas between 0 and –0.5. For call options, delta ranges from 0 to +1, with 0.5 being the ATM point.

Question 23

Forward Contracts

Answer 23

Institutional investors prefer to use forward contracts for the following reasons:

1. Futures contracts are standardized in terms of settlement dates and contract sizes. These may not correspond to the portfolio’s investment parameters.
2. Futures contracts may not always be available in the currency pair that the portfolio manager wants to hedge.
3. Futures contracts require up-front margin (initial margin). They also have intra-period cash flow implications, in that the exchange will require the investor to post additional variation margin when the spot exchange rate moves against the investor’s position. These initial and ongoing margin requirements tie up the investor’s capital and require careful monitoring through time, adding to the portfolio management expense. Likewise, margin flows can go in the investor’s favor, requiring monitoring and reinvestment.

In contrast, forward contracts do not suffer from any of these drawbacks.

Forward contracts are more liquid than futures for trading in large sizes. Reflecting this liquidity, forward contracts are the predominant hedging instrument in use globally.

Question 24

Chicago Mercantile Exchange

Answer 24

Typically, the CME will appeal to those accounts that are trading in smaller dealing sizes.

The CME also provides market access with tight pricing and good liquidity (for these smaller deal sizes) to those accounts that may not have the creditworthiness or the credit relationship with major FX dealers in order to access the FX market through other channels. These less creditworthy accounts are able to access the exchange-traded market because the central clearing house demands margin and guarantees delivery on all contracts.

There is a diverse range of market participants who fit this description, including small hedge funds, proprietary trading firms, and active individual traders. One important class of market participants on the CME are managed futures funds, which are often used by small institutions, high-net-worth individuals, and other accounts that would fall under the realm of private wealth management. These managed futures funds are pools of private capital managed by commodity trading advisors (CTAs).

Note that FX quoting conventions for contracts quoted on the CME are frequently different from those used elsewhere in the currency market. The CME is based in the United States and, as a matter of convention, uses the USD as the price currency in the foreign exchange quote for all currency pairs.

Question 25

Hedge Ratios with Forward Contracts

Answer 25

• A** static hedge** (i.e., unchanging hedge) will avoid transaction costs, but will also tend to accumulate unwanted currency exposures as the value of the foreign-currency assets change. This characteristic will cause a mismatch between the market value of the foreign-currency asset portfolio and the nominal size of the forward contract used for the currency hedge; this is pure currency risk. For this reason, the portfolio manager will typically need to implement a dynamic hedge by rebalancing the portfolio periodically. This hedge rebalancing will mean adjusting some combination of the size, number, and maturities of the forward currency contracts.
• However, we can observe that the higher the degree of risk aversion, the more frequently the hedge is likely to be rebalanced back to the “neutral” hedge ratio. Similarly, the greater the tolerance for active trading, and the stronger the commitment to a particular market view, the more likely it is that the actual hedge ratio will be allowed to vary from a “neutral” setting, possibly through entering into new forward contracts.
• For matched swaps, the convention is to base pricing on the mid-market spot exchange rate.

Question 26

Roll Yield

Answer 26

• The roll yield (also called the roll return) on a hedge results from the fact that forward contracts are priced at the spot rate adjusted for the number of forward points at that maturity.
• A positive roll yield results from buying the base currency at a forward discount or selling it at a forward premium (the intuition here is that it is profitable to “buy low and sell high”). Otherwise, the roll yield is negative (i.e., a positive cost).
• If the futures curve for corn futures contracts is in contango, then this hedging position will also face the potential for negative roll yield.

Question 27

Currency Options

Answer 27

• Matching a long position in the underlying with a put option is known as a protective put strategy.
• This premium is determined, first, by its** intrinsic value**, which is the difference between the spot exchange rate and the strike price of the option (i.e., whether the option is in the money, at the money, or out of the money, respectively). ATM options are more expensive than OTM options, and frequently these relatively expensive options expire worthless.
• The second determinant of an option’s premium is its time value, which in turn is heavily influenced by the volatility in exchange rates. Regardless of exchange rate volatility, however, options are always moving toward expiry. In general, the time value of the option is always declining. This is the time decay of the option’s value (theta, one of the “Greeks” of option prices, describes this effect) and is similar in concept to that of negative roll yield on forward contracts described earlier. Time decay always works against the owner of an option.

Question 28

Strategies to Reduce Hedging Costs and Modify a Portfolio’s Risk Profile

Answer 28

• The key point to keep in mind is that all of these various cost-reduction measures invariably involve some combination of* less downside protection* and/or* less upside potential* for the hedge. In efficient markets, lower insurance premiums mean lower insurance.
• Currency management strategies will differ fundamentally depending on whether the base currency of the P/B price quote must be bought or sold to decrease the foreign-currency exposure. To simplify the material and impose consistency on the discussions that follow, we will assume that the portfolio manager must sell the base currency in the P/B quote to reduce currency risk.

Select Currency Management Strategies:

• Forward Contracts→Over-/under-hedging→Profit from market view
• Option Contracts
  
  • OTM options→Cheaper than ATM
  • Risk reversals→Write options to earn premiums
  • Put/call spreads→Write options to earn premiums
  • Seagull spreads→Write options to earn premiums
• Exotic Options
  
  • Knock-in/out features→Reduced downside/upside exposure
  • Digital options→Extreme payoff strategies

Question 29

Over-/Under-Hedging Using Forward Contracts

Answer 29

If the neutral benchmark hedge ratio is 100% for the base currency being hedged, and the portfolio manager has a market opinion that the base currency is likely to depreciate, then over-hedging through a short position in P/B forward contracts might be implemented—that is, the manager might use a hedge ratio higher than 100%. Similarly, if the manager’s market opinion is that the base currency is likely to appreciate, the currency exposure might be under-hedged.

Question 30

Protective Put Using OTM Options

Answer 30

One way to reduce the cost of using options is to accept some downside risk by using an OTM option, such as a 25- or 10-delta option.

Question 31

Risk Reversal (or Collar)

Answer 31

• We are using the simplifying convention that the manager is long the base currency in the P/B quote; hence puts and not calls would be used for hedging in this case.
• One strategy to obtain downside protection at a lower cost than a straight protective put position is to* buy an OTM put option and write a*n OTM call option. Essentially, the portfolio manager is selling some of the upside potential for movements in the base currency (writing a call) and using the option’s premiums to help pay the cost of the long put option being purchased.
• In professional FX markets, having a long position in a call option and a short position in a put option is called a risk reversal. For example, buying a 25-delta call and writing a 25-delta put is referred to as a long position in a 25-delta risk reversal. The position used to create the collar position we just described (buying a put, writing a call) would be a short position in a risk reversal.

Question 32

Put Spread

Answer 32

• A variation of the short risk reversal position is a put spread, which is also used to reduce the upfront cost of buying a protective put. The short risk reversal is structured by buying a put option and writing a call option: the premiums received by writing the call help cover the cost of the put. Similarly, the put spread position involves buying a put option and writing another put option to help cover the cost of the long put’s premiums. This position is typically structured by buying an OTM put, and writing a deeper-OTM put to gain income from premiums; both options involved have the same maturity.
• The put spread structure will not be zero-cost because the deeper-OTM put (1.3450) being written will be cheaper than the less-OTM put (1.3500) being bought. However, there are approaches that will make the put spread (or almost any other option spread position) cheaper or possibly zero-cost: the manager could alter:
  
  • (a) the strike prices of the options;
  • (b) the notional amounts of the options; or
  • (c) some combination of these two measures.

Question 33

Seagull Spread

Answer 33

An alternative, and somewhat safer approach, would be to combine the original put spread position (1:1 proportion of notionals) with a covered call position. This is simply an extension of the concept behind risk reversals and put spreads. The “core” of the hedge (for a manager long the base currency) is the long position in a put option. This is expensive. To reduce the cost, a short risk reversal position writes a call option while a put spread writes a deep-OTM put option. Of course, the manager can always do both: that is, be long a protective put and then write *both *a call and a deep-OTM put. This option structure is sometimes referred to as a seagull spread.

Question 34

Exotic Options

Answer 34

• In general, the term “exotic” refers to all options that are not “vanilla.” In FX, vanilla refers essentially to European-style put and call options.
• All exotics, no matter how complex, typically share one defining feature in common: They are designed to customize the risk exposures desired by the client and provide them at the lowest possible price.
• The two most common type of exotic options encountered in foreign exchange markets are those with knock-in/knock-out features and digital options.
• An option with a knock-in feature is essentially a vanilla option that is created only when the spot exchange rate touches a pre-specified level (this trigger level, called the “barrier,” is not the same as the strike price). Similarly a knock-out option is a vanilla option that ceases to exist when the spot exchange rate touches some pre-specified barrier level. Because these options only exist (i.e., get knocked-in or knocked-out) under certain circumstances, they are more restrictive than vanilla options and hence are cheaper. But again, the knock-in/out features provide less upside potential and/or downside protection.
• Digital options are also called binary options, or all-or-nothing options. They are called this because they pay a fixed amount if they “touch” their exercise level at any time before expiry (even if by a single pip). This characteristic of “extreme payoff” options makes them almost akin to a lottery ticket. Because of these large payoffs, digital options usually cost more than vanilla options with the same strike price. But digitals also provide highly leveraged exposure to movements in the spot rate. This makes these exotic products more appropriate as trading tools for active currency management, rather than as hedging tools. In practice, digital options are typically used by more sophisticated speculative accounts in the FX market to express directional views on exchange rates.

Question 35

Strategies with currency options

Answer 35

The following steps can be helpful to sort things out:

1. First, identify the* base* currency in the P/B quote (currency pair) you are dealing with. Derivatives are typically quoted in terms of either buying or selling the base currency when the option is exercised. A move upward in the P/B quote is an appreciation of the base currency.
2. Then, identify whether the base currency must be* bought* or sold to establish the hedge. These are the price movements you will be protecting against.
3. If buying the base currency is required to implement the hedge, then the core hedge structure will be based on some combination of a long call option and/or a long forward contract. The cost of this core hedge can be reduced by buying an OTM call option or writing options to earn premiums. (But keep in mind, lower hedging costs equate to less downside protection and/or upside potential.)
4. If selling the base currency is required to implement the hedge, then the core hedge structure will be based on some combination of a long put option and/or a short forward contract. The cost of this core hedge can be reduced by buying an OTM put option or writing options to earn premiums.
5. The higher the allowed discretion for active management, the lower the risk aversion; and the firmer a particular market view is held, the more the hedge is likely to be structured to allow risk exposures in the portfolio. This approach involves positioning in derivatives that “lean the same way” as the market view. (For example, a market view that the base currency will depreciate would use some combination of short forward contracts, writing call options, buying put options, and using “bearish” exotic strategies.) This directional bias to the trading position would be superimposed on the core hedge position described in steps “c” and “d,” creating an active-trading “tilt” in the portfolio.
6. For these active strategies, varying the strike prices and notional amounts of the options involved can move the trading position toward a zero-cost structure. But as with hedges, keep in mind that lower cost implies less downside protection and/or upside potential for the portfolio.

Question 36

Cross-Hedges and Macro Hedges

Answer 36

• A cross-hedge—also referred to a proxy-hedge—occurs when a position in one asset (or a derivative based on the asset) is used to hedge the risk exposures of a different asset (or a derivative based on it).
• Some types of cross-hedges are often referred to as macro hedges. The reason is because the hedge is more focused on the entire portfolio, particularly when individual asset price movements are highly correlated, rather than on individual assets or currency pairs. Another way of viewing a macro hedge is to see the portfolio not just as a collection of financial assets, but as a collection of risk exposures. These various risk exposures are typically defined in categories, such as term risk, credit risk, and liquidity risk. These risks can also be defined in terms of the potential financial scenarios the portfolio is exposed to, such as recession, financial sector stress, or inflation. Often macro hedges are defined in terms of the financial scenario they are designed to protect the portfolio from.

Question 37

Minimum-Variance Hedge Ratio

Answer 37

• A mathematical approach to determining the optimal cross-hedging ratio is known as the minimum-variance hedge ratio.

covariance(y,x)/σ²(x)=correlation(y,x)×[σ(y)/σ(x)]

• The minimum-variance hedge ratio can be quite different from 100% when the hedge is* jointly* optimized over* both* exchange rate movements R_FX and changes in the foreign-currency value of the asset R_FC.
• There can also be cases when the optimal hedge ratio may not be 100% because of the market characteristics of a specific currency pair. For example, a currency pair may not have a (liquid) forward contract available and hence an alternative cross-hedging instrument or a macro hedge must be used instead.
• A Basis risk exists when movement in the hedge currency is not matched by movement in the
  hedging vehicle. A direct hedge will short forwards on the currency to be hedged and basis risk
  will therefore be low. A cross hedge can range from lower to higher basis risk depending on
  what is used as the hedging vehicle. The MVHR depends on regressing past asset returns and
  currency movement to calculate a hedge ratio that would had minimized past volatility of returns
  to the domestic investor in a foreign asset. It is exposed to changing correlation and likely to
  have the highest basis risk.

Question 38

Basis Risk

Answer 38

• The portfolio manager must be aware that any time a direct currency hedge (i.e., a spot rate hedged against its own forward contract) is replaced with an indirect hedge (cross-hedge, macro hedge), basis risk is brought into the portfolio. This risk reflects the fact that the price movements in the exposure being hedged and the price movements in the cross-hedge instrument are not perfectly correlated, and that the correlation will change with time—and sometimes both dramatically and unexpectedly.
• Macro hedges will have to be carefully monitored and, as needed, rebalanced to account for the drift in correlations. Minimum-variance hedge ratios will have to be re-estimated as more data become available. The portfolio manager should beware that sudden, unexpected spikes in basis risk can sometimes turn what was once a minimum-variance hedge or an effective cross-hedge into a position that is highly correlated with the underlying assets being hedged—the opposite of a hedge.
• For all intents and purposes, the minimum-variance hedge for a spot exchange rate using a forward contract will be close to 100%.
• When there is only a single foreign-currency asset involved, one can perform a joint optimization over both of the foreign-currency risks (i.e., both R_FC and R_FX) by regressing changes in the domestic-currency return (R_DC) against percentage changes in the value of the hedging instrument.
• The result will be a better hedge ratio than just basing the regression on R_FX alone because this joint approach will also pick up any correlations between R_FX and R_FC.
• Recent work has shown that the optimal hedge ratio based jointly on movements in R_FC and R_FX for international* bond* portfolios is almost always close to 100%. However, the optimal hedge ratio for single-country foreign equity portfolios varies widely between currencies, and will depend on both the investor’s domestic currency and the currency of the foreign investment.

Question 39

Basic Intuitions for Using Currency Management Tools

Answer 39

Example of a portfolio manager who is long the base currency in the P/B quote and wants to hedge that price risk—the manager needs to understand the following:

1. Because the portfolio has a* long *exposure to base currency, to neutralize this risk the hedge will attempt to build a short exposure out of that currency’s derivatives using some combination of forward and/or option contracts.
2. A currency hedge is not a free good, particularly a complete hedge. The hedge cost, real or implied, will consist of some combination of lost upside potential, potentially negative roll yield (forward points at a discount or time decay on long option positions), and upfront payments of option premiums.
3. The cost of any given hedge structure will vary depending on market conditions (i.e., forward points and implied volatility).
4. The cost of the hedge is focused on its “core.” There are various cost mitigation methods that can be used alone or in combination to reduce these core hedging costs:

• Writing options to gain upfront premiums.
• Varying the strike prices of the options written or bought.
• Varying the notional amounts of the derivative contracts.
• Using various “exotic” features, such as knock-ins or knock-outs.

5. There is nothing inherently wrong with any of these cost mitigation approaches—but the manager must understand that these invariably involve some combination of reduced upside potential and/or reduced downside protection. A reduced cost (or even a zero-cost) hedge structure is perfectly acceptable, but only as long as the portfolio manager fully understands all of the residual risks in the hedge structure and is prepared to accept and manage them.
6. There are often “natural” hedges within the portfolio, in which some residual risk exposures are uncorrelated with each other and offer portfolio diversification effects. Cross-hedges and macro hedges bring basis risk into the portfolio, which will have to be monitored and managed.
7. There is no single or “best” way to hedge currency risk. The portfolio manager will have to perform a due diligence examination of potential hedge structures and make a rational decision on a cost/benefit basis.

Question 40

Special Considerations in Managing Emerging Market Currency Exposures

Answer 40

• Managing emerging market currency exposure involves unique challenges. Perhaps the two most important considerations are:
  (1) higher trading costs than the major currencies under “normal” market conditions, and
  (2) the increased likelihood of extreme market events and severe illiqluidity under stressed market conditions.
• There may also be fewer derivatives products to choose from, especially exchange-traded products.
• The investment return probability distributions for currency (and other) trades subject to such relatively frequent extreme events have fatter tails than the normal distribution as well as a pronounced negative skew. Risk measurement and control tools (such as value at risk, or VaR) that depend on normal distributions can be misleading under these circumstances and greatly understate the risks the portfolio is actually exposed to.
• The occurrence of currency crises can also affect hedging strategies based on forward contracts. Recall that hedging a long exposure to a foreign currency typically involves selling the foreign currency forward. However, when currencies are under severe downward pressure, central banks often react by hiking the policy rate to support the domestic currency. But recall that the higher interest rates go in a country, then, all else equal, the deeper the forward discount for its currency (enforced by the arbitrage conditions of covered interest rate parity). Having to sell the currency forward at increasingly deep discounts will cause losses through negative roll yield and undermine the cost effectiveness of the hedging program.
• Investors who may have believed that they had diversified their portfolio through a broad array of exposures in emerging markets may find instead in crises that they doubled-up their currency exposures.
• Another potential factor affecting currency management in these “exotic” markets is government involvement in setting the exchange rate through such measures as foreign exchange market intervention, capital controls, and pegged (or at least tightly managed) exchange rates.
• Currency crises and government involvement in FX markets is not limited to emerging market currencies, but often occur among the major currencies as well.

Question 41

Non-Deliverable Forwards

Answer 41

Currencies of many emerging market countries trade with some form of capital controls. Where capital controls exist and delivery in the controlled currency is limited by the local government, it is often possible to use what are known as non-deliverable forwards (NDFs). These are similar to regular forward contracts, but they are cash settled (in the non-controlled currency of the currency pair) rather than physically settled (the controlled currency is neither delivered nor received). The non-controlled currency for NDFs is usually the USD or some other major currency.