Some Like It Hedged

Download or read book Some Like It Hedged written by Momtchil Pojarliev and published by CFA Institute Research Foundation. This book was released on 2018-11-07 with total page 37 pages. Available in PDF, EPUB and Kindle. Book excerpt: Foreign currency exposure is a by-product of international investing. When obtaining global asset exposure, investors also obtain the embedded foreign currency exposure. Left unmanaged, this currency exposure acts like a buy-and-hold currency strategy, which receives little or no risk premium and adds unwanted volatility. In “Some Like It Hedged,” the author shows that the impact of foreign currency exposure on institutional portfolios depends significantly on the base currency of the investors and the specific composition of their portfolios. In general, investors whose base currency is negatively correlated with global equities, as are the US dollar and the Japanese yen, will reduce the volatility of their portfolios by fully hedging foreign currency exposure. In contrast, investors whose home currency is positively correlated with global equities, as is the Canadian dollar, will benefit from keeping some unhedged foreign currency exposure—in particular, exposure to the US dollar. Finally, investors with larger allocations to domestic assets will experience only small reductions in volatility from hedging. Pojarliev discusses a variety of options to address foreign currency exposures. Although there is no single best-practice solution for addressing foreign currency exposures, institutional investors have three main choices. Do nothing (i.e., maintain unhedged foreign currency exposure). Doing nothing is always the easiest option, but from a risk–return perspective, it could be the worst available choice. Currency has no long-term expected return because, although it is a risk exposure, it is not an economic asset. Hence, long-term currency returns are expected to be zero. Hedging should, therefore, have no long-term impact on the return and only affect the volatility. The volatility reduction from hedging can be redeployed more efficiently by increasing exposure to economic assets for which a risk premium exists. Hedge passively (i.e., maintain a constant hedge ratio).In general, hedging some of the foreign currency risk will decrease the volatility of the portfolio. The relationship between a specific hedge ratio and the decrease in volatility depends on the particular portfolio and, most importantly, on the base currency of the investor. Yet, passive hedging creates its own problems, including negative cash flow generation when foreign currencies are appreciating and detraction from returns because of hedging costs. Passive hedging might also introduce a major market-timing risk. If the base currency weakens after a passive policy is implemented, the investor will suffer substantial hedging losses when the forward currency hedging contracts settle. Hedge actively (i.e., vary the hedge ratio). One way to address the market-timing risk of implementing a passive hedging program is to actively time the hedging of the foreign currencies. An active hedging program seeks to reduce the risk of the foreign currency exposure but varies the hedge ratios for the various currencies based on market views to avoid negative cash flow and to generate positive returns. A successful active hedging program should both add to the return of the portfolio and lower the volatility, and it should outperform both an unhedged and a passive hedging benchmark. The best choice to address foreign currency exposure will differ from institution to institution, but it boils down to two fundamental factors. First, the optimal solution depends on the importance of risk versus return and the institution’s tolerance for negative cash flow. Second, investors must decide whether they believe that currency managers are able to achieve a positive information ratio over the long run after fees and, importantly, whether they will be able to identify these currency managers. Any currency policy will depend on the details of the specific portfolio—in particular, on the base currency of the investor and the size of the foreign currency exposure.