Currency Overlay
How think and act Big-Players when hedging their
Share-, Currency-, Commodity- and Interest Risk?
In general, the exchange of amounts in different currencies is a zero-
sum game. The reason that some participants of the foreign
exchange market manage their foreign currency positions actively
make it to some of them possible to operate above the zero-border.
Thus, to the burden of other participants.
The Market
The prospect of the foreign exchange market has changed
increasingly in recent years. It is no longer considered as a minor
product of international trading- and capital markets, it is now also
respected as a form of investment. Funds- and Hedge Fund
Manager, whose strategies often don't meet the expectations
because of low volatility in the equity markets, decided to create
foreign exchange strategies and startet to build their own currency
funds. Funds are going increasingly more sophisticated in the use of
currency vehicles in order to increase their gains. At least it will be
tempted so, because the predictability is nearly impossible, because
there are myriad of paramers which couldn't be sufficient calculated,
e.g. human logic.
The Participants
A look into the publications of the
funds shows it: there is no doubt
about that the number of Funds
investing into currencies is having
more and more popularity. On the
contrary most Asset Managers,
Treasurer and Cash Manager deal
with currencies for a transactional
background, i.e. underlying. That
means, behind a trade is in most
cases a "real" transaction with goods or fixed assets, e.g. shares. So
far no pure aim for profit, just rather a hedge or a simple change
from one currency to another currency, because it is needed
physically today or in the future. The behaviour for improvement is
reduced to the negotiation of better prices regarding the change.
Smaller customers do it by phone, middle customers by their
Treasury Management System and larger customers with special
broker-software which is online with multiple banks. The best bank-
offer gets the deal.
The decission of the Bank resp. the Institutional Market
Participant
It can be discussed about the benefits of such software. On the one
side it is just simply easy to calculate the profit threshold for the
market participant, i.e. the customer. On the other hand there is the
question about the timing. Should the order now at 11:00:00, at
11:00:10 or at 11:01:00 executed and where is then the rate? This
coincidence factor cannot be calculated and the band within a
minute in the foreign exchange market can be huge, relatively seen
to the tough negotiations for one or two pips only.
The Winner and the Loser
About one thing all market participants agree: currency risk is always
present, as long as it is not naturally hedged (e.g. assets vs. capital,
revenues vs. expenses in the same currency at the same time). This
risk must be recognized and managed. Banks offer to especially
institutional customers, thereof mainly from the volumes perspective
the funds with their enormous resources, tailored resp. structured
products in order to have the currency exposure under control at
lowest possible costs. But the principle of a zero-sum game is still
present. The questions arise, who are the losers in that global
trading system. At the end of the day all of us in the one or other
form. May it be by direct losses, non-taken gains, higher margins on
the products which we trade or consume daily. Therefore the global
circle is going to be closed. Nevertheless, every market participant is
trying for his own benefit to get his best possible optimum. This
leads to the question where this optimum can be fixed and how high
the tolerance for losses is for each single participant?
Pension Funds which do not manage their currency exposure
proactive and therefore don't hedge, expose themselves clear and
take into account the gains and losses occurred by exchange rate.
Hence, it exists on the one hand a financing matter and on the other
hand a portfolio efficiency question. If Enterprises and Pension
Funds take this risk just into account it can be derived the
assumption that those risks are managed separately in another
asset class in order to get back in the "save" profit zone. Most of the
Companies and Funds drive on a strategy in the middle. That
means, hedge currency exposure partially and additionally the
volatility from price differences occurred by currency exchange
effects.
With the attempt to save the earnings and to expand them, pension
funds continuously increase the part of shares denominated in
foreign currencies. Doing this, they increase their currency
exposure. That in combination with the active management of
investment vehicle is the main reason for the expandation of the
professional category of the Cash Manager. In former times those
tasks have been managed outsourced to specialized companies, but
in line with the always more upcoming internationalization the
currency exchange risk is also increasing. Unification of currencies,
like the Euro, are the absolute exception to reduce that risk.
Get the Optimum, regardless what the intention of the
Market Participant is
It must be distinguished
between
1. Trading, Production and
Service Enterprises (the
companies) and
2. Institutional Investors.
The first group attempt, as already mentioned above, minimizing
their risk while the second group try to generate gains with those
risks. But both have one and the same consensus: get the
optimum out of the currency market.
Currency Overlay
In a strategic and tactical investment process, FX can be a separate
asset class and currency exposure can reduce expected portfolio
risk. Active currency overlay positions are in general uncorrelated
with bond and equity positions. A successful active FX management
increases the portfolio return and should be viewed as a natural part
in a fund's alpha process.
Our Partner, Mercury Control AG, Switzerland, applies a strictly
disciplined style rotation strategy, based on continuous macro,
political and flow analysis across the G7 currencies and are
combined with technical forecasting tools. The trading style itself is
selected from the following options, accordingly:
•
Momentum
•
Range
•
Volatility
Momentung Trading
Momentum Trading acts as the overarching style, inasmuch as it
determines trade execution according to a principal outlook for mid-
to long-term movements governing the FX market. Its role is also to
set the stage for Range Trading - the most commonly applied FX
trading style - by identifying the maximum and minimum range lines
to execute trades, according to risk-return principles.
Range Trading
Range Trading, on the other hand, analyzes the underlying
channeling patterns (range) resulting from currently prevailing "paid
price" scenarios. The clear goal is to trade as long as possible within
such a range in order to maximize the value-adding potential of this
style .
Volatility (Vega) Trading
A final rotation to Volatility Trading occurs when a previously applied
range "breaks out" to either side and no clear continuation is
immediately detectable. As a result, options are written on the
existing short (sold) or long (bought) positions. However, once all
Volatility Trading possibilities are exhausted there is a logical
movement back to Momentum or Range Trading.
The risk or hedge ratio between 0% and 100% and the base
currency specified by the client defines the proportional amount of
the mandate's absolute currency exposure. This means, either an
active or a passive managed mandate.
Active currency management enables the client to reduce
risk and add return to an international portfolio whereas the
passive approach negates the foreign exchange risk and
reduces the diversification benefits from international
investments
Case Study
The following is a case study for a customer:
Related Cash Flows to above mentioned trades:
In other words, a Treasurer with functional currency CHF and need
of reducing FX-exposure for $ 7.2m is now able to compensate his
loss of long USD 7.2m x (1.0741-1.1871)= - CHF 813’600 with the
gain of the overlay transactions whereas a Treasurer or Fund-
Manager with need of opimizing his $ 25m investment achieved an
annualized gross-profit of 28,2%.
Hint: in case of using Currency Overlay for hedging purpose, we
recommend according best practice risk management to apply a
value at risk approach in order to adjust the overlay portfolio to the
current underlying and complete it with an absolute loss amount.
Do you like to know more about Currency Overlay?
Don’t hesitate and contact us.