Currency risk management for asset managers

Asset managers are long-term financial players. Different asset managers can have different perceptions of how they look at an asset that generates a foreign currency cash flow.

While one asset manager can view such currency exposure as a factor that may impair the portfolio return, another asset manager can see the currency exposure as contributing to the portfolio volatility decrease. There is no right or wrong here, as it depends on the investment policy of each asset manager. But this is on the condition that the different asset manager's views have been empirically examined by them.

What you can take from here:

• Just as asset allocation affects return more than “stock picking”, currency risk management policy is more critical than hedging at the “best spreads”.

• Although asset allocation has more effects on the return, asset managers don't neglect stock picking, so neither should the tactical aspect of FX hedging be neglected.

• Currency forecasts have low reliability, and therefore the energy should be directed to the tactical aspects of FX hedging (policy implementation, instruments, pricing tools, and doing shopping).

• Since "dealers systematically and consistently overcharge clients who don’t have currency trading expertise” (Harald Hau) - Asset managers must improve this skill set.

• Hedging via currency options in the OTC market is still an area of knowledge that has not yet reached to full potential and could be the next tiebreaker. 

Currency forecasts - are they worth anything?

Forecasts in the currency market are considered impossible in the short term. However, opinions are divided regarding the long-term currency forecasts' reliability. The low reliability of currency forecasts lies in the complexity of the analysis. The analysis is complicated because it has to consider not just one economy but the performance of one economy in relation to another and sometimes in relation to a third economy. It is clear then that forecasting quality is low, even in the long run. As a result, asset managers also put technical analysis into the decision-making toolbox.

Technical look

Since asset managers are long-term players, the graph to be analyzed is a monthly graph where each candle represents one trading month.

The structure of the graph is similar to a Descending Triangle. The lower boundary of the triangle is a support line, and the upper boundary of the descending triangle is the line of resistance. This pattern generally implies that the breakout can occur in both directions; however, the lower boundary is broken down in most cases. The probability of its occurrence increases as the candles approach the trend lines' meeting point. 

The breakout aggressiveness

Some technical analysts look at the base of the triangle to conclude the depth of the breakout. The question of where to place the base of the triangle is largely subjective, but it doesn’t change the technical assessment that when the breakout occurs, it will be quick and violent to those not on the right side of the breakout direction.

Questions:

1. Does the current month's candle represent a downward break?

2. Are you ready for a scenario where you will be on the wrong side of the breakout?

3. If you had a hedging policy - would it help you in such a scenario? If you already have a policy, do you think it has proven to be beneficial?

4. How can you demarcate the boundaries of the “playground”?

We will not be able to answer all the questions in this post.

In the following articles, we will address the issue of formulating a hedging policy and how to implement it.

In this article, we will concentrate on the tactical aspects of hedging strategies and provide hedging ideas for both exposure directions.

Here are some hedging ideas

Forward table - as a benchmark to all hedging strategies:

For asset managers, with exposure to the euro's depreciation against the US dollar.

Risk reversal (Cylinder):

• Spot: 1.0040

• Expiry: 6 Months (Forward rate: 1.0195). Buy Put at 0.9868 and sell Call at 1.0432.

• Cost: Zero cost.

Similar strategies at Zero cost to other expiries:

• Expiry: 1 Year (Forward rate: 1.0311): Buy Put at 0.9855 and Sell call at 1.0670.

• Expiry: 2 Year (Forward rate: 1.0511): Buy Put at 1.0010 and Sell call at 1.0933.

Forward extra:

• Spot: 1.0027

• Expiry: 6 Months (Forward rate: 1.0168). Buy Put at 1.0034 and sell Call at 1.0034 with European Up&In trigger at 1.0652.

• Cost: Zero cost.

Similar strategies at Zero cost to other expiries:

• Expiry: 1 Year (Forward rate: 1.0303): Buy Put at 1.0144 and Sell call at 1.0144 with European Up&In trigger at 1.0880.

• Expiry: 2 Year (Forward rate:1.0507): Buy Put at 1.0334 and Sell call at 1.0334 with European Up&In trigger at 1.1140.

For asset managers, with exposure to the euro's appreciation against the US dollar.

Risk Reversal with limited potential profit

• Spot: 1.0021

• Expiry: 6 Months (Forward rate: 1.0180). Buy Call at 1.0400, Sell call at 1.1278 and sell Put at 0.9850.

• Cost: Zero cost.

Similar strategies at Zero cost to other expiries:

• Expiry: 1 Year (Forward rate: 1.0316): Buy Call at 1.0700, Sell call at 1.2035, and sell Put at 0.9800.

• Expiry: 2 Year (Forward rate: 1.0524): Buy Call at 1.0900, Sell call at 1.2730, and sell Put at 1.0000.

Name: Something creative

• Spot: 1.0022

• Expiry: 6 Months (Forward rate: 1.0182). Buy Call vanilla at 1.0440 Amount 0.5 Million EUR and buy American barrier Call at 1.0440 with Up&Out trigger at 1.2057 Amount 0.5 Million EUR. Sell vanilla Put at 1.0000 0.5 Million EUR and sell Put at 0.9600 0.5 Million EUR.

• Cost: Zero cost.

Similar strategies at Zero cost to other expiries:

• Expiry: 1 Year (Forward rate: 1.0319): Buy Call vanilla at 1.0580 Amount 0.5 Million EUR and buy American barrier Call at 1.0580 with Up&Out trigger at 1.2170 Amount 0.5 Million EUR. Sell vanilla Put at 1.0100 0.5 Million EUR and sell Put at 0.9700 0.5 Million EUR.

• Expiry: 2 Year  (Forward rate: 1.0532): Buy Call vanilla at 1.0647 Amount 0.5 Million EUR and buy American barrier Call at 1.0647 with Up&Out trigger at 1.2405 Amount 0.5 Million EUR. Sell vanilla Put at 1.0100 0.5 Million EUR and sell Put at 0.9700 0.5 Million EUR.

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