FX Exposure or Hedging: How to add value?
by Patrick Oberhaensli, on Apr 15, 2020 4:45:00 PM
There are multiple ways to add value using Foreign Exchange (FX) derivatives and they can be grouped into two categories: risk management and alpha generation. We will discuss in this article some of the typical approaches as well as the less common applications that can lead to a combination of added value.
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The question of FX hedging can be looked at in terms of reference currency (the investor’s currency in which the performance is measured) and (invested) asset classes. For an investor who’s reference currency is the CHF, meaning a “strong currency”, a common practice would be to hedge all fixed-income in foreign currency and about half the international equities – assuming proper diversification.
Why not completely hedge equities? Because there is a “natural” hedge coming from multi-currency commercial activity. For fixed-income, FX would just add-in volatility as long-term volatility of the USD versus a basket of key currencies is at about 5.75%.
But hedging can also “cost” (beside transaction costs), but that depends on the considered investor: it is purely an arbitrage perspective.
Examining the Swiss Franc
Let’s take the simple case of a Swiss Franc investor (CHF as the reference currency) who wants to hedge his/her USD exposure for the next 3 months using forwards:
A currency pair is quoted as follows: a unit of the base currency / the non-base currency equals the FX rate. This is essential when calculating the value of a forward as the base currency parameters will (always) appear on the denominator.
So, the current USD/CHF forward, noted F, will be F=S*[(1+rCHF*time)/ (1+rUSD*time)]
With S as the Spot at: 0.9880, the 3 month USD interest rate at: 1.8905% while the 3 month CHF interest rate is at: -0.7176%, we obtain: F=0.9880*[(1-0.7176%*(90/360))/ (1+1.8905%*(90/360)]=0.9880*(0.9982/1.0047)=0.9816 or -64 pips (pip for percentage in point) or simply basis points as mid-value which refers to F=S-0.0064=0.9816. The loss (or “cost”) over 3 months is of 0.65%!
What needs to be remembered is that the hedging is based on the short-term interest rate differential while the investments are long(er) term oriented. For fixed income there can still be an advantage due to the yield curve situation. And for equity, if foreign equities outperform well, then it is anyway“fine”: this was clearly the case for US equities in the past years.
For equities from countries with relatively weak currencies, the degree of FX hedging should be increased. Especially as a sharp drop in equities is often associated with a fall in the currency, as seen in the case of Argentina Fall 2019.
Another difficulty comes from the fact that the future price development of the foreign currency asset is unknown: therefore, the hedger can hardly be perfectly hedged since he/she must estimate the volume (at expiration) associated with the performance.
In terms of implementation, it is typical to consider an overlay approach that can also be externalized via a mandate. That institutionalization allows the investor to clearly measure the impact of the hedging through forward and/or futures. The latter is usually related to the generation of alpha which is the topic of the next part just below.
Alpha generation in FX isn’t easy considering the markets have become pretty efficient for the major currency pairs that can be traded without constraints. In other words, the classic risk premia, such as the carry trade, are today often beta rather than alpha. Nevertheless, there are different possibilities to invest in alternative that add value. Here two examples…
The Case of Global Macro Hedge Funds
A very interesting case was when the Swiss National Bank (the Swiss Fed equivalent) halted the targeted EUR/CHF exchange rate on the 15th of January 2015. Given the unsustainable balance sheet required to weaken the CHF, it was a move that at least certain Global Macro hedge funds were able to anticipate. They bet on imbalances getting back to a better balance.
A dominical Newspaper had also “predicted” it, a short time ahead. What happened is that the USD and the EUR immediately weakened versus the CHF beyond 25%. Another interesting aspect of Global Marco is that they could use a large palette of instruments including options but not with the type of extreme leverage that some brokers allowed (for FX instruments).
The Case of Managed Futures
Currencies can also move in trends and that’s what Managed Futures will look for using diverse trend identification and intensity measurement techniques. But in that context FX is likely only one contributor among 4 market segments: FX, fixed-income, equities and commodities. The idea behind that is again diversification – especially as the value added in terms of return is often questioned for efficient markets like the FX one. Worth noting is that Managed Futures will only use futures… or FX forwards but not options – limiting the same way the possibilities to exploit opportunities.
FX exposure is very likely a direct concern for any investor who has a certain level of assets to invest in and looks for diversification, as it will lead to the purchase of international assets. The Investment Policy Statement needs to address the hedging matter (one may also choose not to hedge) and if there should be or not an alpha component. Talking about alpha generation, the next article will discuss a further approach that is unique.
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- The preparation of the information provided herein is done with a high level of care. Nevertheless, errors are possible