2017 06 Currency Hedging Handbook PDF

CURRENCY HEDGING
HANDBOOK
DORI LEVANONI
Partner
PAUL GOLDWHITE, CFA

Director
This handbook is based on First Quadrant’s internal research and is not intended to provide specific
investment advice. Except as otherwise noted, the analysis throughout this document is based on a time
period of January 1980 to December 2016 and uses the following proxies for the referenced asset classes:
Global ex-US equities is a simulated basket of developed market equities based on MSCI World Index; Global
ex-US bonds is a simulated basket of developed market bonds based on the Citi World Government Bond
Index; US bonds is simulated US bonds based on the Citi World Government Bond Index; EM equities is the
MSCI Emerging Markets Index; and EM bonds is the JPMorgan GBI-EM Global Composite Index. Please see
the end of this paper for further details on these proxies.
Past or simulated performance is no guarantee of future results.

Potential for profit is accompanied by possibility of loss.
FOR INSTITUTIONAL USE ONLY. FIRSTQUADRANT.COM

The purpose of this handbook is to serve as a reference for
investors when determining whether and how to manage the
currency exposure arising from their holdings of foreign assets.
The handbook covers the main aspects of managing currency
exposure and is designed for efficient use. Individual chapters
are self-contained, so the reader may select only those chapters
of greatest interest. This handbook is intended to be used as a
tool for practitioners, and some technical details have been left
out to keep the document to a manageable length. When tech-
nical terms are used, they are explained in the text. This version
of the handbook is for US dollar base currency investors. The
framework of analysis remains the same for all base currencies,
however, although the data and some results will be different for
non-US dollar investors.¹
INTRODUCTION
The handbook is organized as follows. We begin with an Executive
Summary that highlights the main considerations discussed in the
body of the handbook. In Chapter 1, we establish the importance of
having a currency policy, due to the significant impact of currency on
portfolios. Currency impact has been rising in recent years and the
evidence suggests that it will rise further. Optimal management of
this currency risk provides opportunities for managing the overall
portfolio more efficiently.
In establishing a currency policy, investors should address two key

questions. The first is what strategic hedge ratio to adopt. The strategic
hedge ratio is an investor’s internal currency benchmark. Analogous to
strategic asset allocation, it’s the static foreign currency exposure that
best satisfies the investor’s long-term objectives. Chapter 2 provides a
roadmap that investors can use to determine their strategic hedge ratio.
The second key question is whether currency exposure should be man-

aged passively (i.e., implementing the strategic hedge ratio on a static
basis) or actively. In Chapter 3, we equip investors with the arguments
and evidence so they can make an informed decision.
Having chosen the strategic hedge ratio and whether to manage pas-
sively or actively, investors are in a position to implement their curren-
cy policy. Chapter 4 covers aspects of implementation – instruments,
counterparties and information flows – to help ensure the smooth op-
eration of the currency policy. Chapter 5 is on monitoring the currency
policy. Its purpose is to indicate what kinds of ongoing reports and
flows of information will be needed to ensure that the results of their
currency policy are correctly interpreted and therefore more likely to
be adhered to throughout a currency cycle. The final chapter provides
a summary and conclusion.
5 EXECUTIVE SUMMARY
CHAPTER 1
9 Importance of having a currency policy
11 Why now?
CHAPTER 2
14 Establishing a currency policy benchmark –
the optimal strategic hedge ratio
14 Global ex-US equities
25 Global ex-US bonds
TABLE OF 26
27
Emerging markets
Other instruments
CONTENTS CHAPTER 3
28 Active/Passive Management
28 Participants in the foreign currency market
29 Types of active management
30 Performance of currency managers
34 Performance of currency factors
35 Constraints on active hedging mandates
37 Costs
CHAPTER 4
39 Implementation
39 Instruments
41 Counterparties
41 Information flows
CHAPTER 5
44 Monitoring Currency Policy
44 Specifying objectives
44 Benchmarking
45 Monitoring return and risk
45 Communication and education
47 CONCLUSION
EXECUTIVE
Currency Hedging Handbook
SUMMARY
EXECUTIVE SUMMARY
Currency risk is a significant source of unrewarded risk for many investors.
If mitigated, currency risk can be redeployed into better return-seeking

opportunities.
Investors should adopt a currency policy addressing two main questions:
• What is the hedge ratio that best meets their investment objectives?
• Should currency exposure be managed passively or actively?
Our analysis for US dollar investors shows that the optimal hedge ratio for
global ex-US developed equities is around 75%, though in practice, ratios
from 50% to 100% can still result in a meaningful improvement in portfolio
return/risk ratio. The 50% hedge ratio has attractive properties, for example,
providing 80% of the benefits of a 75% hedge while also allowing for symme-
try in the hedging activity around the benchmark.
The Currency Hedging Handbook is a in foreign assets because unhedged currency

reference for investors when determining exposure can be a significant portion of an
whether and how to manage the currency investor’s risk budget.
exposure arising from their holdings of Some investors refrain from hedging
foreign assets. The handbook is tailored currency because they believe currency
for US dollar base currency investors, exposure is a source of diversification. If
though results are similar for other this were true, then the risk of a portfolio
base currencies; analysis for other base with currency exposure would be lower than
currencies is available upon request. the risk of the same portfolio with hedged
currency exposure. Our analysis shows
Importance of having a currency policy that this is not the case: currency exposure
An investor’s currency policy consists of consistently increases portfolio risk.
a strategic hedge ratio that maximizes For an investor with global ex-US
expected return/risk (or some other developed equities, currency exposure adds
investment objective) and a method for 2.6% to volatility compared to a fully hedged
implementing the policy, either passively or position, an 18% increase during the time
actively. Currency policy should be an integral period 1980-2016. With global ex-US
part of every investment program that invests developed bonds, currency risk dominates,
FIRSTQUADRANT.COM
EXECUTIVE
SUMMARY
adding almost 6% to the volatility and more return. It is not like other risk premia
than doubling the risk compared to a fully such as the equity risk premium or bond
hedged position. term premium. Empirically, the returns to
Currency risk can also have a unmanaged currency exposure over long
meaningful impact on a diversified time periods have been small, 0.5% per
portfolio. For an investor with 60% equities annum, and depend on the time period.
and 40% bonds, hedging the currency The correlation between the returns of
exposure of foreign developed equities foreign developed equities (currency hedged)
reduces portfolio risk by the same amount and currency is close to zero on average,
as a 7% shift from stocks to bonds. though it varies over time. If the correlation
The risk reduction provided by hedging were persistently and significantly negative,
foreign currency risk allows the investor currency exposure might be diversifying, but
to reallocate the risk to higher-returning this is not the case.
assets, which can aid in meeting overall Currency volatility has also fluctuated
investment objectives. over time, although we have not detected
any persistent trends in volatility since
Why now? 1980. Some have argued that globalization
Currency risk has been growing in portfolios should reduce the currency-related risk of
as allocations to foreign assets have been foreign equities, but we find no evidence
increasing, and exchange rate volatility has of this, either in equity returns or in
been rising from relatively low levels. For corporate earnings.
investors who haven’t yet put in place a
currency policy, there are strong arguments Non-US developed equities
for doing so in the near future. Our analysis shows that for a US dollar base
currency investor, the optimal strategic
Strategic hedge ratios hedge ratio for global ex-US developed
For an investor who seeks to maximize equities is right around 75%. In practice,
return per unit of risk, the strategic hedge however, hedge ratios from 50% to 100% also
ratio can be determined using the same provide substantial benefits. One important
inputs used in developing a strategic conclusion is that it’s difficult to justify, from
asset allocation: expected returns, risks an investment efficiency standpoint, having
and correlations for the assets and a currency benchmark that is unhedged.
currencies. We undertake the analysis for Nevertheless, unhedged benchmarks are
each international asset class separately not uncommon. This implies that for many
as they have very different volatilities and investors, a meaningful improvement in
correlations to foreign currencies. portfolio return/risk can be readily achieved
Unmanaged currency risk should not be by implementing a strategic hedge ratio
expected to generate a positive (or negative) between 50% and 100%.
FIRSTQUADRANT.COM
EXECUTIVE
SUMMARY
Non-US developed bonds of investments. We address two main

For global ex-US developed bonds, the questions: 1) Are there reasons to believe
optimal hedge ratio is 100% because the currency universe offers opportunities
unrewarded currency risk dominates bond to add value consistently? 2) Can skilled
market risk. managers with sufficient capacity be
identified in advance?
Emerging markets There are conceptual reasons to believe
For emerging market (EM) equities and currency markets may not be perfectly
bonds, much of their macroeconomic and efficient, and the data supports this belief.
political risk is transmitted through the Traditional concepts of market efficiency
currency markets, so hedging currency don’t apply as well in currency markets as
would remove much of what gives emerging in, e.g., equities or fixed income, because
markets their distinctive characteristics. for many of the participants in currency
The strategic hedge ratio for EM equities markets, the primary objective is not
and bonds is zero (unhedged). necessarily maximizing the value of their
currency exposure. Instead, for them,
Alternative assets currency is a means to an end—a medium
A currency policy should cover all foreign for exchanging money for goods and
assets, including illiquid and alternative services across borders.
assets, and the framework presented in Historical performance of active
the handbook can be extended to these currency managers also supports the
investments. Because holdings in alternative notion that currency markets are not as
asset classes vary substantially from one efficient as, e.g., their equity counterparts.
investor to another, it is not possible to The median active currency manager
compute a single optimal currency hedge had a significantly higher information
ratio that would apply to all investors. ratio, on average, than the median active
Investors should carry out analysis that global equity manager from January
incorporates the specific aspects of their 2002 to December 2016. Another piece
holdings in alternative assets. of evidence on opportunities to add
value in currency is the performance of
Active or passive management factor-based strategies. We looked at
The second part of the handbook assembles three naïve factors that have been well-
the data and reasoning needed for an known for many years: value, carry and
informed investigation of whether currency trend. Each of these generated positive
exposure should be managed actively or returns (transaction costs and fees are
passively. Investors should approach this not considered) from September 2000 to
question for currency in the same way December 2016, as well as the equally
as for equities, bonds and other types weighted combination of the three factors.
FIRSTQUADRANT.COM
EXECUTIVE
SUMMARY
Implementation and monitoring an experienced currency overlay manager

The final chapters of the handbook cover can be a helpful partner in this regard.
implementation and monitoring. These Once objectives and appropriate
are crucial aspects that require careful benchmarks are established, ongoing and
attention to ensure that investors get the consistent monitoring of the currency policy
most out of their chosen currency policy. is key to its longevity and success. Assessing
Investors should take care to understand the performance difference between the
the various instruments available in portfolio and the benchmark is of course
implementing their currency hedging important; also important, however, is
policy, as different instruments not only tracking their absolute performance, as
provide differing advantages, they expose this is what ultimately contributes to the
the investor to different risks. For example, investor’s portfolio and objectives as a whole.
over-the-counter currency forwards (the Finally, periodic communication about the
most commonly used instrument) allow currency policy – including its objectives as
the investor to choose custom maturity well as its performance – will be important;
dates and notional amounts; however, not only can opinions about currency hedging
unlike futures which trade on an exchange, differ across constituents, they can also
they also create counterparty credit risk. change over time. Additionally, a regular
This risk can of course be mitigated by the program of education can be beneficial as
careful selection of counterparty banks market conditions, and how they relate to
and use of legal and credit documentation; the investor’s currency policy, also change.
FIRSTQUADRANT.COM
CHAPTER 1 Currency Hedging Handbook
CHAPTER 1 requires deliberate action on their part and

therefore needs to be justified, approved
Importance of having a and measured – like other major investment
currency policy decisions. Currency considerations are an
The decision to invest in foreign assets integral part of foreign investments, and
is often driven by the desire for better ideally investors should form their currency
diversification or access to a broader set policies as a pre-condition to investing in
of investment opportunities. Although foreign assets.
currency risk is an integral part of most Prior to undertaking the effort to
forms of international investment, it is hedge, it’s worth examining just how
seldom the main reason for investment. important currency risk is. One way to
When investors purchase the foreign gauge the significance of currency risk
currency needed to acquire a foreign asset, is to compare the risk of holding an
unless further action is taken, the investor international asset class on an unhedged
has incurred currency risk from that point basis versus a fully hedged or local
onward. Investors know they can then currency basis, as in Table 01.
mitigate foreign exchange (FX) risk through Table 01 shows that hedging reduces
hedging, but since hedging is often seen volatility and drawdowns regardless of
as separate from foreign investment, it asset class. For example, for an investor
TABLE 01 - COMPARING ASSET CLASS VOLATILITY UNHEDGED VERSUS FULLY HEDGED

(JANUARY 1980 - DECEMBER 2016)
Unhedged Fully Unhedged Minus Unhedged Compared

Hedged* Fully Hedged* to Fully Hedged*
Panel A: Standard Deviation
Global ex-US equities 17.2% 14.6% 2.6% 18%
Global ex-US bonds 10.8% 4.8% 5.9% 122%
EM equities 18.3% 15.7% 2.5% 16%
EM bonds 10.9% 2.7% 8.3% 308%
Panel B: Maximum Drawdown
Global ex-US equities -75.4% -64.9% — —
Global ex-US bonds -19.0% -9.7% — —
EM equities -65.1% -57.8% — —
EM bonds -34.0% -2.3% — —
Data are annualized standard deviation of monthly returns.

*Global ex-US developed equities and bonds are fully hedged data; EM are local currency due
to data availability, as local currency volatility is very close to fully hedged volatility.
Sources: First Quadrant, L.P., Datastream

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Currency Hedging Handbook CHAPTER 1
with global ex-US developed equities, an into US and global ex-US components.³ The
unhedged position adds 2.6% to volatility weight of global ex-US equities was varied
compared to a fully hedged position, from 30% of the portfolio weight (i.e., half of
an 18% increase over this time period. total equities, or roughly what it would be in a
With global ex-US developed bonds, the global market capitalization weighted index)
increase in volatility is dramatic. Currency down to 10%. This is shown in Figure 01.
risk dominates, adding almost 6% to the An investor with a 30% allocation to
volatility and more than doubling the global ex-US equities would reduce total
risk compared to a fully hedged position. portfolio risk from 9.7% to 9.0% by hedging
Unhedged emerging market equities are away currency risk. To put this in context,
riskier than EM equities in local currency.² this is equivalent to a 7% shift from stocks
The volatility of EM bonds is almost entirely to bonds. In other words, if 9.7% is the right
due to currency exposure. amount of total portfolio risk, that level
Not only can currency risk be a significant could be obtained either from a portfolio
portion of risk at the asset class level, it with 30% foreign equities unhedged/30%
Risk reduction from hedging as a function of foreign

can also have a meaningful impact within a
diversified portfolio. We created a simplified
US equities/40% bonds or 33.5% foreign
equities hedged/33.5% US equities/33%
allocation
portfolio of 60% global developed equities
and 40% US bonds, with the equities divided
bonds. That’s a meaningful difference. Put
more broadly, the risk reduction provided by
Figure 01: Risk reduction from hedging as a function of foreignequity allocation

FIGURE 01 - RISK REDUCTION FROM HEDGING AS A FUNCTION OF FOREIGN
EQUITY ALLOCATION
0.00%
Percent of Risk Reduction
-0.20%
-0.40%
-0.60%
-0.80%
10% 15% 20% 25% 30%
Weight of global ex-US equities
Source: First Quadrant, L.P., Datastream
Risk reduction from hedging, standard deviation
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hedging allows the investor to reallocate the Much of the reason for tackling these
risk to higher-returning assets, which can issues and bundling them into something
aid in meeting overall investment objectives. we’re calling a currency policy is due to the
The data show that currency risk is potential challenges of governance. Currency
significant for most globally diversified has a significant impact on the risk profile of
investors, but what should be done about most globally invested portfolios, and merits
it? There is a compelling case for investors the same degree of attention as other major
to formulate and adopt a currency policy, investment policy questions. Some funds
which is a summary of the analysis and require major investment policy decisions
reasoning regarding a fund’s currency to be approved by a board or committee;
management. It may or may not entail a other funds are less formal. Adopting a
commitment to hedge, but should include sound and rigorously vetted currency policy
two main parts. The first is establishing the promotes consistency through changes in
strategic hedge ratio, i.e., the hedge ratio fund personnel and during periods when
that, if applied on a static basis, does the short-term performance is disappointing.
best job of meeting long-term investment If a fund lacks a currency policy, every
objectives. The strategic hedge ratio is time there is a currency performance
the fund’s internal currency benchmark. surprise – especially when it’s a negative
It may be viewed as the currency version one – the fund will be vulnerable to
of strategic asset allocation. Absent questions about its currency exposure.
a tactical view on currency, the fund There may be pressure to reverse whatever
would hold the strategic hedge ratio. The FX positions the fund currently has (i.e.,
strategic hedge ratio is typically between switching from unhedged to fully hedged,
0% (unhedged) and 100% (fully hedged). or vice versa – and often just at the wrong
It may – and probably does – differ for time), incurring transaction costs and
each international asset class, a topic we sowing confusion. Second-guessing can be
address in the next chapter. The second avoided by having an established currency
part of the currency policy is whether to policy, which imposes discipline on both
manage currency exposure actively or the philosophy and process.
passively. This is analogous to the active/ The assumptions underlying the
passive discussion for stocks and bonds, currency policy should be re-examined
and should be addressed with the same periodically, at the same frequency and
degree of rigor. Another consideration, perhaps the same time as the fund revisits
if any sort of currency hedging, active or its strategic asset allocation.
passive, is contemplated, is whether the
hedging will be undertaken by internal or Why now?
external resources. This issue may also be Why should currency policy be a priority
included in a fund’s currency policy. now? Investors have generally been
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increasing allocations to international There are also fundamental reasons

investment over the past several decades. why currency risk may increase. Global
The reasons for increased international economic policy uncertainty has been
investment are myriad, including better rising, as shown in Figure 03 (next page). In
diversification, a broader set of investment the US for example, the new administration
opportunities and increasing investor has suggested fiscal and trade policies
comfort with foreign markets. The impact, that would represent a large departure
however, is the same – an increase in from those of the previous administration.
currency risk. Even without policy specifics, the currency
Another consideration is currency market has reacted sharply. It is likely that,
volatility. Figure 02 shows rolling 36-month as policy proposals are debated, there will
FX volatility for an investor exposed to the be further currency volatility.
currencies of a global ex-US developed Other assets will also be affected by
equity portfolio. Recently, volatility has changes in government policy, but there
been rising from levels that were low is reason to think the currency markets
by historical standards. As of the end of will be more affected than most because
December 2016, 36-month FX volatility, at much of the policy discussion is directed
6.4%, is below the 36-yearExhibit
average 4: Rollingat
of 8.4%, 36globalization.
month FX volatility
Globalization affects trade
so there is scope for further increases. and cross-border capital flows, among other
Figure 02: Rolling 36 month FX volatility

FIGURE 02 - ROLLING FX VOLATILITY TIME SERIES
15.0
Rolling 36-month FX volatility
10.0
Average FX volatility
5.0
Dec-82 Aug-88 Apr-94 Dec-99 Aug-05 Apr-11 Dec-16
FX volatility is defined as the volatility of returns for global ex-US equities unhedged
minus fully hedged.

Rolling 36 mth FX vol Average FX vol
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Figure 03: Global Economic Policy Uncertainty Index
FIGURE 03 - GLOBAL ECONOMIC POLICY UNCERTAINTY TIME SERIES

(DECEMBER 1996 - JANUARY 2017)
300
200
100
0
Dec-96 May-00 Sep-03 Jan-07 May-10 Sep-13 Jan-17
Source: www.policyuncertainty.com
things, and these are directly connected to investors should be motivated to use their
the foreign exchange markets. risk budgets as efficiently as possible. If a
We would posit one more reason for fund has more currency risk than indicated
taking a close look at currency risk at this by its strategic hedge ratio, that risk can be
time. With the expected returns of major asset redeployed into other investments that are
classes quite low by historical standards, more likely to provide incremental returns.
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CHAPTER 2 TO PROFIT FROM SUCH CURRENCY

MOVEMENTS WOULD NOT BE
Establishing a currency policy AUTOMATIC; IT WOULD REQUIRE
benchmark: the optimal strategic
ANALYSIS AND GOOD JUDGMENT,
hedge ratio
WHICH ARE THE INGREDIENTS OF
In this chapter, we show how to derive
the optimal strategic hedge ratio. SKILLED ACTIVE MANAGEMENT.
We undertake the analysis for each PASSIVE CURRENCY EXPOSURE ON
international asset class separately ITS OWN CANNOT BE EXPECTED
because they have very different volatilities TO GENERATE A POSITIVE (OR
and correlations to foreign currency.4 To NEGATIVE) LONG-TERM RETURN,
determine the “optimal” strategic hedge BUT IT CLEARLY GENERATES RISK.
ratio, we assume that investors wish to
maximize expected risk-adjusted returns,
and employ a multi-dimensional view of returns. Investors demand a reasonable
risk, incorporating standard deviation of return from every risk, and they should
returns and maximum drawdown. avoid any uncompensated risks. Finance
We derive the optimal strategic hedge provides compelling justifications for
ratio using the same technique used for expecting positive long-term returns
building efficient portfolios that maximizes from, for example, bonds (time value of
expected risk-adjusted return. 5 The money and the term premium) and stocks
required inputs are forecasts of returns, (equity risk premium), but this is not the
risks and correlation for foreign currency case for developed market currencies.
and the underlying asset. We construct To be clear, here we are referring to
a template for the analysis with global the return for bearing pure currency
ex-US developed equity. The same exposure, excluding the return from any
template is then also applied to global underlying asset. An example is a US
ex-US developed sovereign bonds. For investor holding non-interest bearing
conciseness, we will henceforth drop the Japanese yen notes in a vault.
term ‘developed’ when referring to global Exchange rate fluctuations are often
ex-US developed equities and bonds. driven by economic fundamentals such as
country to country differences in inflation
Global ex-US equities rates, productivity growth, trade and capital
flows and investor behavior. Exchange rate
Returns movements of this sort may last a long
A fundamental tenet of investment is that time, but they are not permanent. They
investors expose themselves to risk with can stop or go into reverse as economies
the expectation that they will generate evolve. To profit from such currency
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FX hedging using forward exchange traders refer to the difference

FX contracts between the spot and forward rate as
For those less familiar with forward FX forward ‘points’; i.e., the amount added to
contracts, we provide a brief, simplified or subtracted from the spot rate prevailing
discussion here. Forward FX contracts are at the time of the trade.
contracts between two parties that oblige This contract acts as a hedge of the US
them to exchange an agreed amount of one dollar value of the investor’s yen assets
currency for another currency on a fixed because the investor has contracted with
date in the future at a forward exchange rate the bank to receive, in 3 months, a fixed
that is specified at the contract’s inception. amount of dollars. Regardless of whether
For example, if a US dollar investor the yen rises or falls against the dollar
wishes to hedge the currency exposure during the 3-month term, the amount of
of a Japanese yen asset for 3 months, the dollars the investor will receive has been
investor would find a counterparty, usually fixed by the forward exchange rate agreed
a bank, that is willing to enter into a forward at the opening of the contract. (The value of
FX contract. The investor would agree to the yen asset will probably fluctuate in yen
sell a fixed amount of yen (typically equal to terms over 3 months, so forward FX acts as
the current value of the asset) to the bank an approximate hedge, although frequent
in exchange for a fixed amount of dollars adjustments to the amount hedged would
in 3 months from the opening date of the reduce this slippage.)
contract. In 3 months, the investor would In practice, investors hedging the
be required to deliver the agreed amount currency of long-lived assets such as stocks
of yen to the bank, and would in exchange usually avoid exchanging the full face value
receive from the bank the agreed amount of the forward FX contract at the time the
of dollars. This exchange would close, or contract settles because this might entail
settle, the contract. large cash flows which the fund may not
The forward FX rate used in the contract have in a conveniently liquid form, and
is determined by the current exchange which incur transaction costs. Instead,
rate, or spot rate, and the difference in the funds will transact only for the net amount
interest rates of the two currencies. The they gained or lost over the life, or tenor, of
latter quantity, also known as the interest the contract. They can do this by entering
rate differential, or carry, is the return into a second forward FX contract that in
that currency hedgers receive or pay. If effect rolls the hedge forward for another
the foreign currency being hedged has a 3 months (also known as a swap) or, less
lower interest rate than the base currency, frequently, transacting in instruments called
the hedger will receive the interest rate non-deliverable forwards (commonplace
differential. If the foreign currency has in emerging markets; less so in developed
a higher interest rate, the hedger will markets). Contracts can be rolled for as long
pay the interest rate differential. Foreign as the hedge is needed.
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movements would not be automatic; it What do the data reveal about long-
would require analysis and good judgment, term currency returns? Continuing with the
which are the ingredients of skilled active example of global ex-US equity, Figure 04
management. Passive currency exposure isolates the impact of currency hedging on
on its own cannot be expected to generate returns by comparing global ex-US equity
a positive (or negative) long-term return, unhedged returns to fully hedged returns, as
but it clearly generates risk. we did when comparing risks in Table 01 at
A simple thought experiment reveals why the beginning of this chapter.6 For the sake
this is so. Return to the example given above of brevity, we will refer to this difference as
of a US investor holding non-interest bearing the ‘currency effect’. All of the examples in
Japanese yen notes in a vault. Now consider the handbook that refer to currency hedging
the example of a Japanese yen investor use forward foreign exchange contracts with
holding non-interest bearing US dollar notes a 3-month tenor, unless otherwise stated
in a vault. At any given point in time, one (see text box on page 15 for a description
of these investors will have a gain and the of forward FX contracts).7 From January
other a loss from their respective currency 1980 to December 2016, the global ex-
positions. They both cannot rationally expect US equity unhedged return was 10% per
a positive return, unconditionally, from their annum compared to 9.5% fully hedged.
holdings, no matter how long they hold their The unhedged return exceeded the fully
foreign currencies.
Figure 03.5: FX Returns hedged return by 0.5% per annum, but the
FIGURE 04 - RETURN OF FOREIGN CURRENCY BASKET FOR US DOLLAR

BASE INVESTORS
$4,000
$3,500
Unhedged global Fully hedged
$3,000 global ex-US
ex-US equities
$2,500 equities
$2,000 Unhedged minus
fully hedged
$1,500 global ex-US
$1,000 equities
$500
$0
-$500
Jan-80 Feb-86 Apr-92 Jun-98 Aug-04 Oct-10 Dec-16
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difference is highly dependent on the own foreign currency exposures, which

starting and ending points, and should not would make it behave more like a domestic
be interpreted as a return expectation. company in FX terms.
It can be difficult to obtain timely,
Risks accurate data on a company’s underlying
This section develops the forecast exposure to specific foreign currencies.
for currency risk used as an input for Without access to clean fundamental
determining the strategic hedge ratio. We data on the amount of business foreign
assess whether the fundamental drivers of companies conduct in US dollars, we looked
risk have changed over time. If this were at statistical relationships to see what they
the case, then historical measures of risk, reveal about trends in US dollarization of
summarized in Table 02 on the following non-US developed companies. We looked at
page, should be adjusted for this forward- the relationship between movements in the
looking application. We also check to see US dollar and growth of foreign company
if investors with different time horizons earnings and stock prices, both measured
should hedge currency risk differently. in local currency. If foreign companies have
been doing proportionately more business
Globalization in dollars, then their earnings measured in
The risk of currency exposure and hedging local currency should become increasingly
may be affected by globalization. Some sensitive to the dollar. According to our
investors argue that because companies analysis, we didn’t find this to be the case.
have become more global over time, Aside from earnings, we looked directly at
there is less reason to hedge their equity. foreign stock prices (in local currency) to
Multinationals conduct business in see if they had become more sensitive to
many currencies, including possibly the fluctuations of the dollar over time. Again,
investor’s base currency. Markets should we found little evidence of this.
reflect this in the returns of multinational
companies, the argument goes, reducing Time horizon
the necessity of hedging.8 What matters What happens to currency risk when it’s
for US dollar investors, in this debate, is measured over different time horizons?
how much US dollar business a foreign Table 01 presented risk as the annualized
company does, not how much global standard deviation of monthly returns
business it does. Global multinationals and 12-month downside risk, but most
tend to have a certain percentage of their investors have longer horizons. Table 02 on
business in dollars, but they are also apt the next page compares standard deviation
to do business in Europe and Asia-Pacific. of returns for global ex-US equities over
A further complicating factor is that a three time horizons: 1-month, 5-year and
multinational may be hedging some of its 10-year, from January 1980 to December
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2016. 9 Data are annualized to facilitate TABLE 02 - FX VOLATILITY FOR DIFFERENT

comparison over the three time horizons. HOLDING PERIODS (US DOLLAR BASE
We find that unhedged equities are CURRENCY GLOBAL EX-US EQUITY
riskier than fully hedged equities over all PORTFOLIO)
three horizons, but the difference shrinks (JANUARY 1980 - DECEMBER 2016)
from 2.6% p.a. using monthly returns
to 1.6% p.a. at 5 years and 1.2% p.a. at Standard Deviation of
10 years. Equity risk also shrinks as the Returns, Annualized
time horizon extends, though incremental Monthly Rolling Rolling
currency risk as a proportion of equity 5-year 10-year
risk remains roughly constant at around Unhedged 17.2% 11.9% 6.3%
one fifth, which is significant.10 We would posit
that perceptions of risk are subjective, and Fully hedged 14.6% 10.3% 5.1%
most investors who consider themselves
Unhedged minus 2.6% 1.6% 1.2%
to have long time horizons still care about fully hedged
intermediate returns.
FX risk as % of 17.8% 15.5% 23.5%
Figure 02 (page 12) showed rolling fully hedged risk
36-month volatility for a US dollar investor
Currency effect* 8.4% 5.0% 2.7%
exposed to the currency basket of a global
ex-US equity portfolio. We see no evidence *Currency effect is the return of global ex-
of a structural shift in currency risk for US US equities unhedged minus global ex-US
dollar base investors despite the lower- equities fully hedged
than-average levels we have seen recently
and, as this is a strategic benchmark, we Sources: First Quadrant, L.P., Datastream
are inclined to use the historical monthly
average volatility of 8.4%. sometimes offer for not hedging is that
they believe currency to be diversifying. If FX
Correlations were diversifying, currency exposure would
The third input is the correlation between reduce the risk of foreign assets measured in
the foreign currency return and the return to US dollars, but we already know from Table 01
global ex-US equity fully hedged.11 We have that it can increase the risk of foreign assets.
argued above that currency exposure does Before we look at the data on correlation,
not, on its own, warrant an expected return, might there be fundamental drivers
but it’s conceivable that currency return that influence the correlation? If foreign
patterns could be sufficiently diversifying currencies are weak and the US dollar
to reduce the risk of global ex-US equity strong, that would tend to increase the local
returns (translated into the investor’s base currency earnings of foreign companies
currency). One of the reasons investors that conduct some of their business in US
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dollars for two main reasons (assuming prospects affects the local equity market
all else equal). First, to the extent that negatively and at the same time reduces
foreign companies generate profits in US the attractiveness of the market for foreign
dollars, the local currency value of those investors. This could lead to a positive
dollars will be greater. Second, if foreign relationship between foreign currency and
companies price their products in their foreign equity. Also, as mentioned earlier,
home currency, the US dollar price of their multinational companies located outside
products will decline, potentially leading to the US conduct business in US dollars and
greater demand from US dollar customers in many other currencies as well. The US
and higher sales volumes. The same dollar may not be the dominant foreign
influences would work in reverse when currency relationship.
foreign currencies are strong and the dollar A handful of currencies have been called
weak. This relationship could give rise to ‘safe haven’ currencies because it is thought
a negative correlation between foreign that those currencies will perform better
currency and foreign equity, which would than others during bad times in markets
indeed be diversifying. We seldom observe and economies. This may be because the
it in the data, however, in part because all countries with the safe haven designation
else isn’t equal. are viewed as open to foreign capital flows,
For example, sometimes a macro having prudent macroeconomic policies and
event such as disappointing GDP growth being less vulnerable to a global economic
Figure 04: Correlation between FX returns and hedged equity
returns, rolling 36 months
FIGURE 05 - ROLLING FX CORRELATION WITH GLOBAL EX-US EQUITIES FULLY HEDGED
(DECEMBER 1982 - DECEMBER 2016)
0.8
0.6
0.4 Rolling 36-month FX correlation

0.2
Average FX correlation
0.0
-0.2
-0.4
-0.6
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downturn or global inflationary surge. The and this is borne out in the data, where there
currencies identified as safe havens shift is little evidence of consistent correlations.
over time, and safe haven status depends Figure 05 on the previous page shows the
on an investor’s base currency. The Swiss rolling 36-month correlation of FX with
franc and Japanese yen are sometimes global ex-US equity fully hedged. The
considered safe haven currencies. We correlation will be positive when foreign
mention safe haven currencies because, if currencies move in the same direction as
the US dollar acted like one, then foreign foreign equities (fully hedged), and negative
currencies would tend to depreciate against when they move in opposite directions. The
the US dollar at the same time as foreign average correlation over the full period is
equities were weak, resulting in more an insignificant 0.05, although there are
positive correlations. That was the case in periods when the correlation is materially
the recent financial crisis, but the pattern is positive (around 0.3 or more) and negative
hardly consistent over time. During the dot- (-0.3 or less). Thus we assume a correlation
com bubble of the late 1990s to early 2000s, of zero for US dollar investors.
for example, the correlation between foreign Figure 06 builds on Figure 05 by adding
currency and foreign equities was negative. a second data series that is the difference
In searching for a fundamental in risk (standard deviation) between global
explanation for correlation, the arguments ex-US equity unhedged and fully hedged.
go in both directions for US dollar investors, Table 01 showed that, on average, the risk of
Fig 05: FX correlation and volatility difference

FIGURE 06 - ROLLING 36-MONTH FX CORRELATION AND UNHEDGED MINUS FULLY
HEDGED VOLATILITY
8.0 0.8
7.0 Volatility difference: Global ex-US equities, 0.6
6.0 unhedged minus fully hedged (LHS)
5.0 0.4
4.0
3.0 0.2
2.0 0.0
1.0
0.0 -0.2
-1.0
-0.4
-2.0 FX Correlation (RHS)
-3.0 -0.6
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Fig 06
FIGURE 07 - RETURN AND RISK AS A FUNCTION OF THE STRATEGIC HEDGE RATIO
20.0% 0.66
18.0% Risk (LHS)
16.0% 0.64
14.0% 0.62
12.0% Return (LHS)
10.0% 0.60
8.0%
6.0% Return/Risk (RHS) 0.58
4.0% 0.56
2.0%
0.0% 0.54
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Strategic hedge ratio
unhedged equity exceeds the fully hedged TABLE 03 - INPUTS FOR STRATEGIC
risk by 2.6%. Yet there are a few periods HEDGE RATIO
when the unhedged risk of global ex-US
equity is slightly lower than fully hedged, Expected return of FX exposure 0.5%
and Figure 06 shows that these periods
Expected volatility of FX exposure 8.4%
are driven by sharply negative correlations
between currency and fully hedged equity. Expected volatility of global ex-US 14.6%
In fully 87% of 36-month periods, however, equity, fully hedged
the risk of the fully hedged position is lower Expected correlation between FX 0.0
than the unhedged position, which argues and equity
strongly for some degree of hedging. Sources: First Quadrant, L.P., Datastream
Results The exact result from the inputs in Table

Table 03 shows the historical data used for 03 is 74%, but note that there can be some
the inputs (except for correlation, assumed variability in the inputs by changes in the
to be zero, as discussed earlier). date range or methodology. The result
The result is that a strategic hedge remains in the region of 75% under most
ratio of right around 75% is optimal for conditions, however. 12 Figure 07 shows
US investors with global ex-US equities historical returns, risks and return/risk as
whose objective is to maximize return/risk. the strategic hedge ratio is varied from 0% to
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100%. The peak improvement in return/risk depreciation. It’s a compromise that also
is indeed attained for hedge ratios between provides most of the return/risk benefits
70% and 80%. The 50% hedge ratio has 80% of the optimal strategic hedge ratio.
of the potential improvement in return/risk. One simplification we’ve employed in
A 100% hedge ratio is slightly less optimal this analysis is to assume investors use the
than a 75% hedge ratio.13 same hedge ratio for each of the currencies
Table 04 summarizes the pros and cons in global ex-US equity. An extension could
of four different hedge ratios commonly be to undertake this analysis separately for
used by investors. It’s worth mentioning each currency, so that instead of a single
the 50% hedge ratio. One of its properties strategic hedge ratio there would be as
is that, because it’s half way between the many different hedge ratios as there are
two endpoints of 0% and 100% hedged, it foreign currency exposures. In our view,
is said to minimize the ‘regret’ that some such an approach, while not necessarily
investors experience over the course of unreasonable, is closer in spirit to active
an up-and-down currency cycle. When management than the benchmarking
an investor is unhedged, and foreign exercise we are carrying out here.
currencies depreciate substantially, with The focus here is on the US dollar
the benefit of hindsight, they may wish they investor, but it is instructive to see how
had a 100% hedge. On the other hand, if a strategic hedge ratio of 75% compares
an investor is fully hedged, and foreign to the strategic hedge ratio for investors
currencies appreciate, they may wish they with different base currencies. Is a 75%
had instead been unhedged. A 50% hedge hedge ratio an outlier, or are US dollar
gives investors half the gain of any foreign base investors members of a broader
currency appreciation or half the loss of any community of global investors who would
TABLE 04 - PROS AND CONS OF DIFFERENT HEDGE RATIOS
Hedge Pros Cons

ratio
0% No transaction costs or hedging Uncompensated risk; higher drawdowns
infrastructure needed
50% 80% of the improvement in return/risk; Transactions costs; hedging infrastructure

minimizes regret needed
75% Optimal: maximizes return/risk; Transactions costs; hedging infrastructure

somewhat lower drawdowns needed; requires MPT methodology
100% Close to optimal; minimizes risk; Transactions costs; hedging infrastructure

lower drawdowns needed
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TABLE 05 - STRATEGIC HEDGE RATIOS FOR base currency equities. The exhibit has
INVESTORS IN GLOBAL EQUITIES, BY BASE three columns. The first is the investor’s
CURRENCY base currency. The second column is the
Optimal Optimal optimal strategic hedge ratio using the
(Historical (Zero historical correlation between foreign
correlation) correlation) currency returns and fully hedged foreign
AUS 66% 111% equity, and the third column is the same
as the second except we used a correlation
CAN 37% 102%
of zero instead of the historical one.
DEN 114% 121% Whether to use the historical correlation
or a zero correlation depends on whether
EMU 64% 69%
you believe there is a fundamental basis
HKG 67% 51% for the historical correlation, or if it may
be distorted by special factors or is simply
JPN 100% 84%
noise and should be ignored. In the case
NWY 88% 121% of the US dollar base, we believe zero is
the right answer because we don’t find
NWZ 101% 152%
a sufficiently strong fundamental case
SNG -10% 67% to use the historical correlation, and the
correlation is quite close to zero in any case.
SWD 43% 75%
As shown in the table, the US dollar
SWI 84% 68% strategic hedge ratio is not an outlier. Most
other base currencies also have hedge
UK 79% 95%
ratios between 50% and 100%. When you
USA 82% 75% work through the math, given the inputs
of volatility, correlation and return, several
Sources: First Quadrant, L.P., Datastream base currencies have theoretically optimal
strategic hedge ratios greater than 100%,
be better off hedging a substantial but in practice few investors would be
portion of the currency exposure of their inclined to hold a strategic hedge ratio
foreign equities? greater than 100%.
Table 05 uses the same analysis as For the safe haven Swiss franc and
above, but from the perspective of a Japanese yen, the optimal hedge ratios
selection of different developed market using their historically positive correlations
base currencies. In each case, investors are 16% higher than if the correlation is
have the same objective of maximizing assumed to be zero, a modest difference.
expected risk-adjusted returns of the Several currencies exhibit the opposite
currency exposure of their global ex- behavior, where the correlation between
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foreign currency and foreign equities tends three commodity exporters, the optimal
to be negative, so the optimal hedge ratio hedge ratio ranges from 66% to 101%.
using the historical correlation is lower than Returning to the earlier discussion on
if the correlation were assumed to be zero. how time horizon affects risk, we repeated
For most of these base currencies, some the analysis using multi-year inputs. This
foreign currency exposure is diversifying. assumes that investors are indifferent to
For some of these countries – notably short- and medium-term currency risk and
Australia, Canada, New Zealand and Norway only care about returns at the end of the
- commodity exports are an important part holding period. When the results are assessed
of their economy. During global economic for rolling periods varying from 2 to 20 years,
downturns, commodity prices are often the average optimal hedge ratio was about 50%.
weak, putting downward pressure on
the currencies of commodity exporters. Drawdowns
Investors in commodity-exporting countries The optimal strategic hedge ratio of 75%
experience base currency weakness was derived using standard deviation as
when global equities are weak, reducing the measure of risk, but for some investors
– though not eliminating – the benefits drawdown is a more pertinent measure of
of currency hedging. For Canadian dollar risk. Would switching the risk measure to
base investors, the optimal hedge ratio is drawdown change the optimal strategic
a relatively low 37%, although for the other hedgeFigure
ratio? If07
the concern is mitigating the
: Optimal Hedge Ratios For Different Objectives
FIGURE 08 - OPTIMAL HEDGE RATIOS FOR DIFFERENT OBJECTIVES

120%
100%
80%
60%
40%
20%
0%
Return/Risk One-month Max Drawdown Mean
Drawdown Drawdown
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FIRSTQUADRANT.COM
worst peak-to-trough drawdown, then the bonds. The conceptual framework and
most effective hedge ratio would have been assumptions we set out above also largely
100% (fully hedged), based on the historical apply to bonds. 14 The inputs, however,
data. If the concern is mitigating the mean are quite different. Table 01 showed that
peak-to-trough drawdown, then 70% would currency volatility dominates the risk
have been optimal – quite close to the 75% profile of global ex-US bonds. Currency
figure. A 70% hedge ratio would also be volatility, on its own, is almost double the
optimal if the objective is to minimize the volatility of global ex-US bonds fully hedged.
worst one-month drawdown. Thus, based on An investment in global ex-US bonds
the analysis, the 75% strategic hedge ratio is unhedged is effectively an investment in a
not only the best answer for maximizing the basket of foreign currencies, which means
Sharpe ratio, but also quite close to optimal a large increase in risk with no incremental
for mitigating mean or worst one-month expected return.
drawdown risk. Figure 08 on the previous The correlation of monthly returns
page summarizes the optimal hedge ratios between foreign currency and global ex-US
for these objectives. bonds fully hedged is 0.6. Foreign currency
exposure, far from diversifying global
Global ex-US bonds ex-US bonds, adds additional risk. The
We repeat the exercise for US dollar significant positive correlation may indicate
investors holding global ex-US sovereign that currency investors and global bond
Exhibit 12: FX correlation and volatility difference - bonds

FIGURE 09 - ROLLING 36-MONTH FX CORRELATION AND UNHEDGED MINUS FULLY
HEDGED BOND VOLATILITY
(JANUARY 1980 -DECEMBER 2016)
Volatility difference:
10.0 global ex-US bonds, 0.6
9.0 unhedged minus
8.0 fully hedged (LHS) 0.4
7.0 0.2
6.0
5.0 0.0
4.0
3.0 -0.2
2.0 -0.4
FX correlation (RHS)
1.0
0.0 -0.6

Volatility difference: global ex-US bonds, unhedged minus fully hedged (LHS) FX correl (RHS)
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TABLE 06 - STRATEGIC HEDGE RATIOS FOR correlation between foreign currency and
INVESTORS IN GLOBAL BONDS, EXCLUDING fully hedged bonds is zero, or 110% if one
BASE CURRENCY believes the 0.6 correlation is meaningful.
Investor base Optimal Optimal Either way, a reasonable strategic hedge
currency (Historical (Zero ratio would be 100%.
correlation) correlation)
Table 06 compares the foreign bond
Australia 109% 104% strategic hedge ratio for investors with
Canada 113% 103% different base currencies. The hedge ratios
are all fairly close to 100%. The US dollar
Denmark 99% 109% investor is not a special case with respect
Euro area 89% 95% to hedging the currency exposure of bonds.
Japan 87% 96% Emerging markets

Norway 106% 107% We use the same framework to assess the
currency exposure of emerging market
New Zealand 108% 106% equities and bonds, but the inputs differ
Sweden 98% 96% from those used for developed market
equities and bonds, leading to very
Switzerland 85% 95% different conclusions. A greater proportion
United Kingdom 100% 101% of the risk of emerging markets comes
from country-level macroeconomic and
US 110% 98% political factors compared to developed
markets. Because currency markets reflect
macroeconomic and political risks, much
investors are looking for similar underlying of the reason for investing in emerging
economic conditions when they invest. markets is transmitted by the currency
Figure 09 on the previous page shows markets. Hedging away emerging market
the 36-month rolling correlation and the currencies would remove a large portion of
difference in volatility between unhedged and the emerging market characteristics that
fully hedged global ex-US bonds. While there are a primary reason for investing in those
were a few periods when the correlation was markets in the first place.
significantly negative, because currency is so The macroeconomic and political
much more volatile than the hedged asset, risks of emerging market currencies are
the volatility of the unhedged bonds is always reflected in the riskiness of the exchange
substantially higher than the volatility of the rates and in the high interest rates of many
fully hedged bonds. of those currencies. Hedging high interest
The strategic hedge ratio for global rate currencies is expensive, and would
ex-US bonds is 98% if one believes the reduce substantially the expected return
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from emerging market investment. Our of expected return, risk and correlation
research has shown that hedging away to foreign currency. Because holdings in
EM currency risk from EM equity and bond alternative asset classes vary substantially
indices essentially provides (expensive) from one investor to another, it is more
developed equity and bond exposures, difficult to generalize about their expected
respectively, while retaining very little EM- return, risk and correlation than for the
specific exposure.15 traditional classes analyzed above, and
Table 07 summarizes the strategic therefore more difficult to supply an
hedge ratios derived in Chapter 03. optimal currency hedge ratio.
For example, within hedge fund
TABLE 07 - STRATEGIC HEDGE RATIO MATRIX allocations, the weights of specific
FOR US DOLLAR BASE CURRENCY INVESTORS types of hedge funds vary widely across
Equities Bonds investors. Some investors will have a
higher weighting of equity long/short
Developed markets 75% 100% funds while others may emphasize fixed-
income arbitrage. The optimal currency
Emerging markets 0% 0%
hedging treatment of these two types of
Source: First Quadrant, L.P. hedge funds is quite different.
Without knowing, at a minimum, the
Hedging other types of investments weights of the different types of funds
A currency policy should cover all foreign within an investor’s hedge fund allocation,
assets, including illiquid and alternative it would be pure speculation to supply an
assets, and the framework presented here optimal currency hedging ratio for a hedge
can be extended to these investments. The fund allocation.16 For alternative assets, one
required inputs are the same: estimates size rarely fits all.
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FIRSTQUADRANT.COM
CHAPTER 3 (or risk-adjusted return) from their

holdings, but this is not the case for
Active/passive management many participants in the currency market.
Having established the strategic hedge ratio, Currency is a medium of exchange, and
investors must decide whether to implement a large number of currency transactions
their currency policy actively or passively. They are driven by an immediate need to
should approach this question for currency consume goods or services denominated
in the same way as for equities, bonds and in a foreign currency. This kind of trade is
other types of investments. Active currency driven by a combination of price, quality
management offers the same benefits as and convenience of the goods and services
active management in other assets: a potential involved. While the valuation of a foreign
source of incremental, diversifying return currency is one input, it isn’t the only
that improves a portfolio’s return/risk. It also factor that determines which goods and
carries the same risk of underperformance services are consumed.
while incurring management fees. Another example of a participant whose
While investors have their own methods main motivation is not necessarily profit
for deciding whether to manage actively or maximization is a central bank. Central
passively, the basic template usually covers banks use currency transactions as one
these questions: 1) Does the investor believe tool for implementing macroeconomic
the asset class offers ways to add value policies. They may be willing to be on the
consistently? 2) Can skilled managers with losing side of a transaction if it furthers
sufficient capacity be identified in advance? their wider policy objectives.
This section is arranged as follows. Figure 10 on the next page shows the
We start with a discussion of participants main categories of currency participants and
in the currency market because this is how much of the market each represents.
related to the potential for adding value. Currency managers and portfolio flows
Then we review types of active currency (driven by investors) account for only 13%
management, followed by an examination of of the market. These are the participants
the track record of the universe of currency most concerned about maximizing value
managers. The next section is about from their foreign currency exposure.
constraints on active currency mandates. Mergers and acquisitions and foreign
We conclude with a discussion of the costs direct investment account for another
of passive hedging and active management. 4%. Currency matters for these long-
term investors, but is often a secondary
Participants in the foreign consideration.
currency market Trade flows, central banks and tourism
Investors in stocks and bonds are usually are less driven by currency values. The
interested in maximizing the return remaining participant, the largest, is
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FIGURE 10 - WORLD CURRENCY TRADE IT WOULD SEEM, HOWEVER, THAT

(DECEMBER 2016) THE EMH MIGHT NOT APPLY TO
CORPORATE TRADE THE SAME EXTENT IN CURRENCY,
TREASURY FLOWS
45% WHERE FOR SO MANY OF THE
33%
PARTICIPANTS CURRENCY IS NOT
THE MAIN CONCERN, BUT MERELY
THE MEANS TO AN END.
PORTFOLIO
M&A, FDI FLOWS
4%
8% For one thing, the critical importance of
TOURISM
3% CURRENCY currency markets to the real economy
CENTRAL MANAGERS
BANKS means that currency is among the most
5%
2% susceptible of the financial markets to
politically motivated intervention. This adds
Sources: BIS, IMF, US Federal Reserve,
World Tourism Organization, Datastream, to both the challenges and opportunities
First Quadrant, L.P. for active managers in this field.
Types of active management

corporate treasury, whose currency This section describes the different types
transactions cover a range of activities of active currency management. Managers
including financing, intra-company sometimes combine more than one of
transfers and hedging. these categories into a single product.
The Efficient Market Hypothesis
(EMH), which says that asset prices Discretionary
reflect all available information, offers a Discretionary currency managers use
plausible conceptual explanation for why fundamental analysis, sometimes combined
active managers in stocks and bonds with technical analysis, to form views on
sometimes struggle to outperform their specific exchange rates. They exercise
benchmarks. It would seem, however, discretion over which inputs are relevant to
that the EMH might not apply to the a particular exchange rate, and the choice
same extent in currency, where for so of inputs may change over time as market
many of the participants currency is not conditions evolve. The forecasting horizon
the main concern, but merely the means varies from short-term to long-term.
to an end. While this might imply that
currency markets are prone to exploitable Factor-based
inefficiencies, we would not suggest that C u r re n c y re s e a rc h e r s , l i ke t h e i r
currency managers have an easy task. counterparts in equities and fixed
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income, have for many years analyzed the as value, carry and trend. Commoditization
relationships between the fundamental occurs when a factor receives large inflows
characteristics, or factors, of a currency of investor money, driving down returns
and its subsequent performance. Rigorous and reducing diversification benefits. A
factor-based investors require that disadvantage of less well-known factors
each factor they use has a fundamental is that there is less academic research on
economic rationale for why it might work.17 them, so the underlying rationales may not
In currency markets, three factors have be as well understood.
achieved elevated status: they have been
known for many years and are supported Dynamic hedging
by a large body of academic work; there Dynamic hedging is an approach to
are plausible reasons for why they work; managing currency that has as its main
they have worked in many time periods objective mitigating downside risk, though
and in many currencies; and they are it may also seek to add returns. It is a
investible even for large investors. The kind of portfolio insurance for currency
three factors are value, carry and trend. exposure. Some versions use put options
Precise definitions for the factors differ while others use the forward FX market
among investors. The text box on the next dynamically to create option-like payoffs.
page summarizes these factors. There are A benefit of this approach is downside
also many other potential factors beyond protection, but this comes at the cost
these three (see discussion of systematic of an explicit or implicit premium. The
fundamental managers below). approach is implemented by reacting
Factor investors implement their to currency moves and does not require
chosen factors systematically. The factors currency forecasts. Whether the approach
are transparent and straightforward to can add value depends on the nuances of
implement and there are many variations the particular strategy and the behavior of
on how managers combine factors. They are currency markets. If the markets exhibit
sometimes called ‘smart beta’ strategies. significant trend-like behavior, dynamic
hedging may add value. A potential pitfall
Systematic fundamental with versions of dynamic hedging that seek
Systematic fundamental management is to replicate option-like behavior without
an extension of the factor-based approach. actually using options is gap risk – the
This approach goes beyond value, carry and risk that markets move too rapidly for the
trend, employing a range of less well-known strategy to respond effectively.
factors based on fundamental aspects of
currency market and investor behavior. An Performance of currency managers
advantage of using less well-known factors is Earlier in this chapter we showed that
that they are not as prone to commoditization a sizeable fraction of currency market
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Currency Factors in Brief is needed to entice investors to hold

Value: One definition is purchasing the riskier currency. While the higher-
power parity (PPP), which uses the yielding currency may depreciate,
law of one price to assess whether a historical depreciation has tended to be
particular currency is cheap or expensive less than indicated by the interest rate
compared to another. The strategy buys differential, thus generating profits.
the inexpensive currency and sells the Trend: Also called momentum, and
expensive currency. The rationale is compares exchange rates based
that if a currency is deeply undervalued, on their returns over short-term to
consumers would switch to importing medium-term time horizons. A twelve-
goods from that country and away from month look-back period is often used.
countries with similar goods but more The strategy buys currencies that
expensive currencies. Eventually, the have been appreciating relatively
increase in demand for the inexpensive strongly and sells ones that have
currency would raise its value. been depreciating. A rationale is that
Carry: The difference in interest rates exchange rate momentum reflects
between two currencies. The interest changes in underlying fundamentals,
rate tenor may vary, but are often tenors which some market participants
of one year or less, which correspond to respond to with a delay. As participants
the tenors of typical forward FX contracts. eventually become aware of the
The strategy buys the higher-yielding changing fundamentals, their market
currency and sells the lower-yielding activity drives further appreciation
one. One rationale is that relatively high (depreciation) of the currencies with
interest rates signal higher currency fundamentals that are improving
risk, and the interest rate differential (deteriorating) on a relative basis.
participants are not primarily in the to maximize the value of the currency
currency market in order to maximize the exposures they manage. If, as a group,
value of their currency exposure — other they are able to add value consistently
motives matter more. It’s conceivable that over time, it suggests that there are
this creates inefficiencies in the currency exploitable features of the currency market.
market, although it is difficult to know with If collectively they cannot add value, it could
certainty. One piece of evidence, albeit mean that the currency market is highly
indirect, is the track record of currency efficient, or that most managers are not
managers. This is one group of currency sufficiently skilled to capitalize on the
market participants who are motivated opportunities that are present.
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What do the data show? Using a 0.2. This suggests that if investors had only a
database of currency manager track random ability to select currency managers,
records, we plotted aggregate manager no better than throwing darts at a board, the
performance for rolling 3-year periods from average investor would outperform gross of
2002 to 2016.18 The plots show the gross fees in each 5-year period. Even if investors
performance of the median manager in selected the lower quartile manager, they
each 3-year period and the upper and lower would have outperformed (gross) more often
quartile managers. Figure 11 shows this than not in each five-year period.
data for excess return over each manager’s To put performance of the universe
respective benchmark, and Figure 12 (next of currency managers in context, we
page) for the information ratio. compared it to a universe of global
Figure 11 shows that the median developed equity managers in Table 09
manager in every 3-year period generated (page 34). The managers in the currency
a positive excess return gross of fees. Table universe performed, on average, better
08 (next page) divides the same underlying than the managers in the global equity
data into 3 non-overlapping 5-year periods universe. The information ratios of the
(2002-2006, 2007-2011 and 2012-2016). upper quartile, median and lower quartile
The median information ratio averaged currency managers were consistently
0.5 (gross) in those periods, and the lower higher than the information ratios for
quartile managers had an average IR of the global equity managers at the same
FIGURE 11 - ROLLING 3-YEAR EXCESS RETURN

Upper
Ex Return (%pa)
Median
Lower
Median
Source: Mercer
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FIGURE 12 - ROLLING 3-YEAR INFORMATION RATIO

Upper
Information Ratio
Median
Lower
Source: Mercer
performance quartiles in each of the Another way of interpreting the data is that
5-year periods. if an investor is more skillful in choosing
The track records suggest that if an global equity managers than currency
investor is able to select currency managers managers, the reward from active currency
as well as they can select global equity management may nevertheless be similar to
managers, the currency universe offers that achieved from global equity managers.
better opportunities for outperformance. Over the 15-year period, for example, the
TABLE 08 - UNIVERSE OF CURRENCY MANAGERS, 5-YEAR TRACK RECORDS
Periods: Jan 2002 to Jan 2007 to Jan 2012 to Average of

Dec 2006 Dec 2011 Dec 2016 3 periods
Excess Upper Quartile 4.7% 3.8% 3.5% 4.0%

Returns
% p.a. Median 1.9% 1.2% 2.0% 1.7%
Lower Quartile 0.3% 0.0% 0.8% 0.4%
Information Upper Quartile 1.3 0.7 0.9 1.0

Ratio
Median 0.8 0.3 0.5 0.5
Lower Quartile 0.4 0.0 0.3 0.2
# Managers 40 48 32 40
Source: Mercer
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TABLE 09 - UNIVERSE OF GLOBAL EQUITY MANAGERS, 5-YEAR TRACK RECORDS
Periods: Jan 2002 to Jan 2007 to Jan 2012 to Average of

Dec 2006 Dec 2011 Dec 2016 3 periods
Excess Upper Quartile 6.1% 1.8% 0.8% 2.9%

Returns
% p.a. Median 1.7% 0.3% -0.2% 0.6%
Lower Quartile -0.2% -1.2% -1.5% -1.0%
Information Upper Quartile 1.2 0.4 0.3 0.6

Ratio
Median 0.5 0.1 -0.1 0.2
Lower Quartile 0.0 -0.3 -0.4 -0.2
# Managers 129 185 183 166

Source: Mercer
information ratio of the upper quartile global equal-weighted combination of them. Table
equity manager was 0.6, which is slightly 10 (next page) is a numerical summary of
higher than the 0.5 information ratio of the the same data.
median currency manager. The three factors all generated positive
The number of currency managers returns with information ratios ranging
in this universe averaged about 40 over from 0.2 to 0.4 (excluding costs). Carry
the time period, and 32 in the recent was the riskiest of the factors, especially in
5-year period. While the number is small terms of downside risk. The 3-factor equally
compared to other types of investments weighted combination performed well, with
– the same database has over 160 global an information ratio of 0.6 and less downside
equity strategies – capacity should not risk than any individual factor. This study
be an issue.19 This is because developed shows that naïve strategies in the public
market currency is one of the most liquid domain added value, another indication that
financial markets in the world, with over US there is scope to add value in currencies.
$5 trillion in daily volume. The live track records of managers and
the performance of naïve strategies are
Performance of currency factors not entirely independent, however. Some
Another piece of evidence on opportunities managers use these factors as one of
to add value in currency is the performance several inputs to their strategies. These
of factor-based strategies. The results two analyses taken together provide some
can be found in Figure 13 (next page).20 In evidence of the opportunities available for
addition to the three factors, we included an active currency managers.
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- bonds
Figure
FIGURE 13 09: Value,
- TIMESERIES carry,
CHART trendVALUE
OF CARRY, and combination,
AND TREND cumulative returns
(SEPTEMBER 2000 - DECEMBER 2016)
180 Carry
170 Value
160
150
140
Combination
130
Trend
120
110
100
90
Aug-00 May-03 Feb-06 Oct-08 Jul-11 Apr-14 Dec-16
Sources: Deutsche Bank AG and First Quadrant, L.P.
Constraints on active hedging p e rce n t a g e o f t h e a m o u n t

mandates of underlying foreign assets
This section addresses potential currency denominated in that currency.21,22
exposure constraints on active currency • Limiting expected tracking error
mandates. Constraints are often imposed versus the currency benchmark.
on active hedging mandates for risk • Prohibiting the use of currencies
management purposes. A few examples of that are not in the underlying assets.
potential constraints are: There are many possible variations on
• L i m i t i n g n e t e x p o s u re i n these constraints. Because an investor’s
each currency to some fixed base currency may go through extended
TABLE 10 - NUMERICAL SUMMARY OF CARRY, VALUE AND TREND

(SEPTEMBER 2000 - DECEMBER 2016)
(ANNUALIZED)
Value Carry Trend Combination
Return 3.3% 2.9% 1.4% 2.8%
Standard Deviation 7.8% 9.1% 8.5% 4.4%
Information Ratio 0.4 0.3 0.2 0.6
Maximum Drawdown -13.8% -30.5% -18.9% -6.6%

12 Months
Source: Deutsche Bank AG
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cycles of appreciation and depreciation, during periods of base currency weakness,

the interaction between these constraints the hedges will lose money.
and the strategic hedge ratio may have During these periods, investors will
a significant impact on the medium- be generating gains from the currency
term performance of an active currency exposure of their underlying assets while
mandate. A crucial determinant of that their constrained currency manager
impact is whether the position constraints may be underperforming relative to a
are symmetrical around the strategic hedge 0% strategic hedge ratio. The combined
ratio (or currency benchmark). return of currency exposure and the
An example of an asymmetric constraint impact of the manager’s hedging may well
is when the strategic hedge ratio is 0% be positive, but less than the gain of the
(unhedged) and the currency manager is currency exposure on its own.
limited to net currency exposures between The situation will be reversed in
0% and 100%. In this case, if foreign periods of base currency strength. Much
currencies are going through a lengthy of the manager’s hedging activity will be
period of strength versus the base currency, generating gains relative to a 0% hedge
it will be difficult for a manager to add value ratio. Including hedging gains, the investor
during such periods. The reason is that most will likely suffer an absolute loss from
of the time the manager attempts to hedge currency exposure during such periods.
With asymmetric constraints, the
TABLE 11 - EXPECTED IMPACT OF manager’s performance will be biased
CONSTRAINTS WITH DIFFERENT STRATEGIC by the direction of the trend in the base
HEDGE RATIOS currency. A proper evaluation of the
manager would require a full currency
Strategic Performance bias of cycle, which might take many years.
Hedge constrained active manager* If net currency exposure is constrained
Ratio during periods when base
currency is:
between 0% and 100%, this would be
symmetrical if used with a 50% strategic
Appreciating Depreciating
hedge ratio. In this situation, a manager
would have equal opportunities to
75% Underperform Outperform
outperform or underperform during base
currency strength or weakness. Table 11
100% Underperform Outperform
summarizes the expected relationship
50% None None between strategic hedge ratios, constraints
and manager performance.
0% Outperform Underperform One function of position constraints is
that they may bind the manager’s hedging
*Constrained to exposure range 0%-100% activity to the underlying foreign asset
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exposures. The first and third sample the size and liquidity of the market. The
constraints at the beginning of this section first kind of trade, which we’ll call ‘spot’
have this effect. Mandates for currency trades for convenience, can be more
hedging are often constrained in this way, expensive than the second because it
but they don’t have to be. Constraints can be entails a transfer of exchange rate risk, and
much looser and untethered to underlying exchange rates are not static. Roll trades
currency exposures. are less expensive because their risk is
For a skilled manager, loosening determined by interest rate differentials,
constraints tends to improve risk- which are usually fairly stable.
adjusted performance. With respect to other types of
instruments, FX futures contracts also
Costs incur generally low transactions costs,
Currency hedging, passive or active, incurs though without the benefit of custom
several kinds of costs: settlement dates. Options, on the other
• Transaction costs hand, can be expensive and, depending on
• Management fees (active) or the structure used, can require an explicit
implementation costs (passive) outlay of premium.
• Monitoring / oversight costs
• FX prime broker fees (optional) Transaction costs
Transaction costs are incurred when Passive hedging programs require trades
trading instruments used for currency when they are initiated, plus additional
hedging, and also if it’s necessary to trades when the amount of underlying
buy or sell portfolio assets to meet the assets changes due to movements in
liquidity demands of the hedging program. the underlying markets and inflows or
Transaction costs depend on market outflows. Passive programs also utilize
conditions, the amounts traded, the method lower-cost roll trades, typically once every
used for trading, as well as the types of three months. We estimate the transaction
instruments (discussed in Chapter 4) and costs of a passive 100% hedge may be as
which currencies are being traded. There low as 5 basis points per year.23
are no explicit per-trade costs or fees, Transactions costs can be higher
however, with the possible exception of for active management than for passive
prime broker fees in some cases. hedging because of the potential for a
Two kinds of trades are common with greater volume of transactions, although
forward FX contracts: 1) trades that change this varies according to the type of
the amounts being hedged, and 2) trades management. An additional potential
that roll existing hedges forward to a future modest cost is an FX prime broker (please
date. In developed market currencies, both see text box on prime brokers on page 40
kinds of trades are quite inexpensive given for additional details).
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Management fees and/or Active management fees vary widely,

implementation costs and are available as a fixed percentage
A large investor may have internal of the amount of underlying assets, and
resources available for implementing a sometimes as a performance fee with
passive hedging program without incurring a small base fee. Performance fees
much additional cost. Smaller investors will can be problematic in mandates with
need to set up an internal capability or pay asymmetric constraints because of
an external manager for implementation. the performance bias discussed in the
Some custodians, for example, offer constraints section. Extended trends in the
currency hedging as an additional service. base currency would lead to long periods
Beyond implementation, investors will need during which the manager received either
to devote some effort to monitoring and minimal performance fees or substantial
reporting on performance. performance fees.
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CHAPTER 4 ONCE AN INVESTOR DECIDES TO

HEDGE CURRENCY RISK, EITHER
Implementation ACTIVELY OR PASSIVELY, THERE
Once an investor decides to hedge currency
ARE A NUMBER OF ITEMS THAT
risk, either actively or passively, there are
MUST BE ADDRESSED TO ENSURE
a number of items that must be addressed
to ensure smooth implementation of the SMOOTH IMPLEMENTATION OF
program. The first section covers the THE PROGRAM.
main types of financial instruments used
in currency hedging. The second section
addresses counterparties and the impact requirement purposes. Once the account is
of changes in regulations. The third section set up with the initial margin requirement,
is on flows of information. the account will be credited/debited on a
daily basis, in base currency, the gains/
Instruments losses of the positions based on changes
The three main financial instruments in the price of the futures contracts. The
used for managing currency exposure are margin account will need to meet the
forwards, futures and options. Forwards and minimum amount of margin required
futures have a similar impact on portfolios, (which is established by the exchange) in
although there are technical differences order to keep positions open. Traditionally,
between them that may make one or the forwards have cash flows only once, on the
other more suitable in specific applications. settlement date, and don’t require margin.
Options have quite a different impact on See the discussion below on counterparties,
portfolios. Forward contracts were covered however, for how regulatory change is
in an earlier text box (page 15), and below we driving convergence between forwards and
will briefly cover futures and options. futures in terms of counterparty risk and
collateral requirements.
Futures Because futures trade on an exchange,
The main difference between futures they are less flexible than forwards.
and forwards is that futures trade on an There are futures contracts on the major
exchange whereas forwards trade over- exchange rates, but not on less-traded
the-counter (OTC).24 The counterparty to exchange rates. Futures are limited
a futures contract is the clearinghouse to specific quarterly settlement dates,
of the exchange, while for forwards it is a and each contract is for a standardized
bank. Clearinghouses tend to have better amount of currency. Forwards have none
credit ratings than many banks. Also, of these limitations: they cover virtually
clearinghouses require participants to fund every exchange rate, any settlement date
margin accounts for initial and daily margin (excluding weekends and holidays) and
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FX prime brokers that would ordinarily be out of scope

FX prime brokerage is a bundled set of for institutional investors, without the
services provided by banks to clients need for additional legal documentation
trading in the currency markets. (other than with their prime broker).
Originally the purview of hedge funds, In addition to providing efficient
usage of FX prime brokerage expanded access to trade execution, prime
after the Global Financial Crisis across brokers also provide real-time netting
a wide range of institutional investors of positions (which may allow for
including corporations, mutual funds, decreased settlement risk and efficient
pension funds and sovereign wealth use of credit lines, potentially reducing
funds, to name a few. This expansion collateral requirements), trade clearing,
was due primarily to the enhanced and some optional ancillary services
liquidity that prime brokers were seen (one which is of particular interest to
to provide. The changing regulatory hedge funds is introduction to new
landscape not only served to constrain sources of investor capital).
the market-making function of There are clearing costs (also known
counterparties, but also increased the as “trade-away fees”) if trade execution
need for legal documentation (ISDAs is done with counterparties other than
and accompanying CSAs). the prime broker, so the enhanced
With the use of a prime broker, liquidity and operational efficiency do
investors are able to trade with any not come without some cost. In addition,
number of counterparties, including concentration of counterparty risk can
smaller regional or specialist banks also be a concern.
any amount of currency (see text box on currency exposure, but an expensive
forwards on page 15). one. See also the discussion in Chapter
3 on dynamic hedging, a technique using
Options forwards that seeks to replicate some
Someone who buys an option has purchased aspects of option behavior. Most currency
the right to make a currency exchange at options trading is OTC, though there are
the agreed strike price, but is under no a limited number of exchange-traded FX
obligation to do so. An option buyer will get options. OTC options are subject to similar
the better outcome, regardless of whether credit and counterparty considerations
the exchange rate moves up or down, but as forward FX contracts, and exchange-
at the cost of the option premium. Options traded options have similar credit and
are a powerful instrument for managing counterparty considerations as FX futures.
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Counterparties because they involve extensions of credit.

Counterparties should be assessed by These new requirements to set aside
average transaction costs, credit quality more capital for risk-taking activities have
and willingness to provide liquidity, among constrained the ability of banks to commit
other criteria. to market-making across asset classes,
OTC instruments involve an extension including currency, limiting the traditional
of credit between the parties, at times role of banks as liquidity providers relative
substantial.25 If a forward contract has a to prior to the financial crisis.
large unrealized gain owing to an investor, Prior to the Global Financial Crisis,
for example, the bank on the other side of the institutional investors such as corporations
contract is a major debtor to the investor.26 and pension funds often executed in the
Investors should thus set a minimum currency markets without the benefit of
threshold for counterparty credit quality. documentation that delineated counterparties’
They should have multiple counterparty legal responsibilities to each other.
banks, to ensure best execution in trading After the crisis, however, banks began
and to diversify counterparty risk. Investors increasingly to require such institutions to
may also wish to set position limits for expand their legal agreements beyond the
counterparties according to any differences traditional swaps and options, to currency
in credit quality.27 Although the credit quality transactions. These legal agreements, known
of major banks declined due to the financial as ISDA agreements, are templates that
crisis of 2008, restricting the universe of highly were originally created by the International
rated counterparties, this trend appears to be Swaps and Derivatives Association in the
reverting somewhat. Nevertheless, investors 1980s to apply to the burgeoning swaps and
should have a process in place for monitoring derivatives markets. Amended several times
counterparties on a regular basis. since, the current “Master Agreement” lays
out the roadmap for two counterparties’
Impact of regulations exchange of currency, including provisions
During the financial crisis of 2008, for termination, default, netting and, if
regulators and investors were very including a Credit Support Annex (CSA), lines
concerned about the solvency of financial of credit. Although a standardized template,
institutions. These concerns led to a wave many investors and banks customize specific
of regulatory reforms, many designed provisions in both the Master Agreement
to bolster the capital position, and (via the “Schedule”) and CSA, requiring
thereby improve the solvency of, banks negotiation of sensitive key terms.
and insurance companies in good and
especially bad times. Information flows
OTC derivatives, including FX forward Smooth operation of a currency hedging
contracts, have come under scrutiny program requires periodic exchanges of
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information between the investor and the SMOOTH OPERATION OF A CURRENCY

currency manager. HEDGING PROGRAM REQUIRES
PERIODIC EXCHANGES OF INFORMATION
Investor to manager
BETWEEN THE INVESTOR AND THE
The manager needs to know the amount of
CURRENCY MANAGER.
underlying assets in each currency to be
hedged. This information should be updated
on a timely basis, especially when there exposures are driven by fluctuations of the
are large changes in underlying assets index. From time to time, it will be necessary
from changes in asset allocation, inflows, for the investor to change the assumed
outflows or price fluctuations. Failure to amount of underlying assets due to inflows,
inform the manager of such changes could outflows and so forth. An advantage of
result in over- or under-hedging relative to this method is ease and transparency. A
the underlying assets. Computations of the drawback is that actual underlying assets
performance of the currency manager and may not match at all times the currency
associated benchmark, as well as fees and exposures being managed.
performance fees, if any, are also linked to If an investor has active managers for
changes in underlying assets. some of their foreign assets, coordination
The manager doesn’t need to know with the currency manager may be needed.
anything else about the underlying assets; Some international equity managers
there is no reason to disclose the holdings. never hedge currency, in which case no
The investor can provide this information coordination on that front will be required. If
directly to the manager. If there is a custodian the international equity manager regularly
bank, it may be easier to instruct the hedges currency as a source of value-
custodian to supply the requisite information added, that portion of foreign assets should
directly to the manager, although there can be excluded from the currency manager’s
be a risk of error in any indirect transmission mandate. Otherwise, there is the possibility
of information. The manager also needs to that the investor will at times be overhedged
know who the approved counterparties are – i.e., have a net short position in a foreign
and position limits. currency, which may not be desirable.
Another method used to communicate
foreign currency exposures is to link them Manager to investor
to an index rather than the actual assets. In The currency manager needs to inform the
this arrangement, an investor would instruct investor as unrealized gains and losses
the currency manager to hedge the currency accumulate so that the investor will be
exposures of an index such as MSCI EAFE, ready to provide liquidity if needed, or
assuming some initial amount of underlying to reinvest when the forward contracts
assets. Changes in the managed currency settle. If the hedging program uses a daily
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mark-to-market mechanism, cash flows

will take place daily, or as required, and
communication will be needed between
the investor and their counterparties (or
prime broker).
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CHAPTER 5 Consider a fund that represents equities

in its strategic asset allocation using
Monitoring currency policy a global all-country benchmark. For
All major aspects of an investment program the purpose of managing securities,
should be monitored regularly, and let’s assume the fund breaks up the
currency policy is no exception. This applies benchmark into three segments: US,
whether the currency policy is managed global ex-US developed, and emerging
passively or actively. The first two sections markets. Let’s further assume that the
of this chapter cover objective-setting and fund has adopted a currency policy with a
benchmarking. The last two sections are 50% hedged benchmark for global ex-US
about monitoring and communication. developed currencies.
For now, we focus on the global ex-US
Specifying objectives developed segment. The fund has managers
For a passive hedging program, a small of the underlying equities, and a separate
amount of slippage in returns versus a manager for the currency exposure of the
currency benchmark should be expected. global ex-US developed segment. The fund
If the slippage is excessive, however, needs an appropriate benchmark for its
transaction costs may be the culprit, and equity and currency managers. The equity
will require further investigation. The risk managers have the usual kind of unhedged
of a passive hedging program should very equity benchmark. The fund also needs a
closely match the risk of its benchmark. benchmark for the currency manager, but
For an active hedging program, what should that be?
there should be a mutual understanding It should be the target portfolio that the
between investor and manager regarding currency manager visualizes as they manage
performance expectations, and a reasonable currency exposure. That portfolio consists
time period allowed for evaluating of a set of underlying currency exposures
performance. We refer the reader to whose weights are given by the country
the discussion in Chapter 3 on position weights of the equity benchmark. In this
constraints, and how they can affect short- case, because the fund has a 50% hedge
to medium-term performance expectations. policy, 50% of each currency exposure in the
benchmark is hedged into US dollars. The
Benchmarking hedging within the benchmark is provided
Benchmarking a currency hedging by hypothetical forward FX contracts.28 Note
program is different from benchmarking that the currency benchmark excludes the
other asset classes because currency returns of the underlying equities because
ex p o s u re u s u a l ly co m e s f ro m a n the currency manager has no control over
underlying foreign asset which is not the them and does not, in effect, ‘see’ them; they
responsibility of the currency manager. are the responsibility of the equity managers.
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There are two benefits to having this CURRENCY RISK HAS BEEN
type of currency-only benchmark. First, it
GROWING IN PORTFOLIOS AS
is the most transparent and accurate way
ALLOCATIONS TO FOREIGN ASSETS
to benchmark a currency manager. Second,
HAVE BEEN INCREASING, AND
it is an effective way to monitor the impact
EXCHANGE RATE VOLATILITY HAS
of currency on the portfolio independently
from the underlying assets. BEEN RISING FROM RELATIVELY
The fund needs a suitable benchmark LOW LEVELS. FOR INVESTORS
for each mandate, and it also needs a way WHO HAVEN’T YET PUT IN PLACE
to aggregate the performance of individual A CURRENCY POLICY, THERE ARE
mandates in order to track performance for STRONG ARGUMENTS FOR DOING
each asset class and for the entire fund. In SO IN THE NEAR FUTURE.
this example, the fund’s benchmark is global
ex-US developed equities, 50% hedged.
The aggregate portfolio performance for limited to a single measure. Some investors
this segment is the performance of all monitor standard deviation of returns as
of the relevant equity managers plus the well as drawdowns.
performance of the currency manager’s Assessing the difference in performance
portfolio of forward FX contracts. between portfolio and benchmark is crucial
for evaluating how well the currency
Monitoring return and risk policy is being implemented. It is also
The return of the currency hedging portfolio useful to track the absolute performance
is calculated using an approach similar of the currency benchmark and portfolio
to the one described in the section on because these contribute to overall fund
benchmarking. The underlying foreign performance and investor objectives.
currency exposure is exactly the same as in
the benchmark. The return of the forward Communication and education
contracts (or other instruments, if applicable) Communication on currency policy is
is added to the return of the foreign currency especially important because opinions
exposure.29 The difference in returns between differ across the investment industry
the portfolio and benchmark therefore comes on how to deal with currency exposure.
down to the difference in returns between the Once they have implemented their
actual forward contracts and the hypothetical currency policy, investors should regularly
ones (if any) in the benchmark. communicate to their management
Portfolio and benchmark should be its objectives, the principles on which
compared on the basis of return and risk. it is based and performance. In such
Risk should be evaluated in the terms most communications, it will be useful to
relevant to the investor, and need not be make a clear distinction between: (1) the
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performance of the strategic hedge ratio; returns and/or reducing risk relative to
and (2) its implementation. The strategic the strategic hedge ratio.
hedge ratio is designed to maximize Communications regarding a currency
return/risk and facilitate efficient use of the hedging program should, ideally, be
risk budget. Regarding implementation, supplemented with a regular program of
if a passive approach is employed, the education regarding the currency market
objective is to execute the strategic hedge environment and how it relates to the
ratio at a reasonable cost. An active investor’s currency policy. Investment
implementation, on the other hand, will managers, consultants and counterparties
have its own objectives of augmenting can often assist with this.
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CONCLUSION Currency Hedging Handbook
CONCLUSION 50% hedge ratio allows for symmetrical

hedging activity around the benchmark.
Currency policy should be an integral part This makes it easier to assess the active
of every investment program that invests management program, regardless of
in foreign assets. Our goal in writing this whether the base currency is strengthening
handbook is to provide in one place the basic or weakening.
information investors need to establish One important conclusion is that it’s
a sound currency policy. Currency policy difficult to justify, from an investment
consists of a strategic hedge ratio that efficiency standpoint, having a currency
maximizes expected return/risk (or some benchmark that is unhedged. Nevertheless,
other investment objective) and a method unhedged benchmarks are not uncommon.
for implementing the policy, either actively This implies that for some investors, a
or passively. The methodology presented meaningful improvement in portfolio
here is rigorous and transparent, and return/risk can be readily achieved by
applies widely available inputs using the implementing a currency policy in which
principles of modern portfolio theory. the strategic hedge ratio is between 50%
Currency risk has been growing in and 100%. The savings in the risk budget
portfolios as allocations to foreign assets from reducing unrewarded currency risk
have been increasing, and exchange rate can then be redirected to other sources of
volatility has been rising from relatively low incremental return.
levels. For investors who haven’t yet put in The second part of the handbook
place a currency policy, there are strong assembles the data and reasoning needed
arguments for doing so in the near future. for an informed investigation of whether
The key result of the analysis is that currency exposure should be managed
for a US dollar base currency investor, the actively or passively. Traditional concepts
optimal strategic hedge ratio for global ex- of market efficiency don’t apply as well
US developed equities is around 75%. In in currency markets as in, e.g., equities
practice, a range of hedge ratios from 50% to or fixed-income, because for many of
100% is also expected to provide substantial the participants in currency markets,
benefits. The 50% hedge ratio tends to have the primary objective is not necessarily
attractive properties, especially if an investor maximizing the value of their currency
envisions managing currency exposure exposure. Instead, for them, currency
actively. The 50% hedge ratio provides fully is a means to an end - a medium for
80% of the potential improvement in return/ exchanging money for goods and services
risk (relative to optimal). Also, assuming that across borders. Performance data of active
the investor wants to limit currency exposure managers support the notion that currency
to the amount of underlying foreign assets markets are not as efficient as their equity
(currency exposure range 0% to 100%), the counterparts. The median active currency
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Currency Hedging Handbook CONCLUSION
manager had a significantly higher business, however (except for commodity-linked

information ratio than the median active companies).
9
5-year and 10-year horizons use rolling returns
global equity manager.
spaced one month apart.
The final chapters of the handbook cover 10
See Kenneth Froot (1993) for another perspective
implementation and monitoring. These on time horizon.
are crucial aspects that require careful 11
The relevant correlation is between foreign
attention to ensure that investors get the currency and global ex-US equity fully hedged,
and not with global ex-US equity unhedged in base
most out of their chosen currency policy.
currency because the latter contains the effects of
foreign currency. Local currency returns would give
   very similar correlations to those using fully hedged
returns.
Endnotes 12
The exact result from the inputs in Table 03 is
¹We invite non-US dollar investors to contact the 74%, but note that there is some uncertainty in the
authors for the relevant version. inputs if one varies the date range or methodology.
2
Table 01 uses local currency volatility for emerging The result remains in the region of 75% under most
market equities and bonds. Local currency volatility circumstances, however.
is very close to fully hedged volatility. 13
We find it encouraging that our own analysis using
3
For ease of illustration purposes, we used this recent data (through December 2016) arrives at a
simplified portfolio example. similar result as Fischer Black in his seminal 1989
4
Currency exposure also affects some domestic assets, paper, which arrived at an optimal hedge ratio of
notably companies with global operations or global 77%. Black, Fischer. “Universal hedging: Optimizing
supply chains. For reasons of scope, this handbook is currency risk and reward in international equity
confined to foreign assets. portfolios.” Financial Analysts Journal (1989): 16-22.
5
Mean-variance optimization, which is part of modern 14
One aspect where bonds differ from stocks is that
portfolio theory, MPT. the cash flows from sovereign bonds are not affected
6
The reason we don’t compare unhedged returns to by currency fluctuations in the same way that the
local currency returns is that local currency returns equities of multinational companies are. Exchange
are not obtainable by foreign investors. rates are an important driver of the earnings of
7
We could use foreign exchange futures contracts, multinationals, and earnings drive equity returns.
but these are not available for as many currency 15
See Jeppe Ladekarl and Edgar E. Peters, Emerging
pairs or are as flexible as forward contracts. In any Market Currency: The Common Risk Factor in
case, the results would not differ materially for our Emerging Markets, The Journal of Investing, Fall 2013.
purposes. 16
We can work with investors on a case-by-case
8
An extreme hypothetical example illuminates the basis to provide currency hedging guidance for their
argument. Suppose there exists a Japanese company alternative assets.
that does the vast majority of its business in the US: 17
Because there are so many potential factors, in the
most of its factories, offices and customers are in absence of a plausible rationale it would be easy to
the US, yet the company is listed on the Tokyo Stock find factors that happened to work over a period of
Exchange and its stock trades in yen. The market time, but were spurious, i.e., statistical noise, and
probably understands such a company, and its risk therefore lacking in predictive power.
profile likely reflects its dollar orientation. US dollar 18
Source: Mercer.
investors shouldn’t hedge this company (although 19
To be included in the 5-year analyses, a manager
Japanese investors should!). There are few non-US must have reported its performance throughout the
companies with such a concentration in US dollar entire 5-year period.
48
FIRSTQUADRANT.COM
CONCLUSION Currency Hedging Handbook
20
Source: Deutsche Bank. The Carry Index (“Carry”) 23
Costs could be somewhat higher, depending upon
systematically buys the top three-yielding currencies the trading method employed and counterparties,
out of the G-10 and sells the bottom three-yielding among other factors.
ones based on three-month yields, with the position 24
Futures are transacted by broker-dealers.
re-appraised every three months. As with any carry 25
The credit risk of exchange-traded instruments is
trade the aim is to extract the risk premium for limited to a one-day price movement. One-day price
taking currency risk. movements, however, can be quite large.
The Momentum Index (“Trend”) systematically 26
Of course this also works in reverse: when the
buys the three currencies with the highest return counterparty bank has a large unrealized gain on a
over the previous year and sells the three currencies forward, the investor is a debtor.
with the lowest returns. The idea here is to profit 27
A counterparty with a higher credit rating might
from the fact that currencies trend over time as have a larger position limit than a counterparty with
prices adjust slowly to new information. a lower rating, for example.
The Valuation (PPP) Index (“Value”) buys the 28
Some index vendors publish returns for currency
three most undervalued currencies and sells those benchmarks where the currency weights match
three that are most overvalued based on the concept the weights of the foreign assets in that vendor’s
of purchasing power parity – on the basis that corresponding equity or fixed-income indices. Some
research suggests this concept holds up in the long vendors also publish returns of fully hedged currency
term, which means currencies tend to move towards exposures (again, excluding underlying asset
a measure of fair value. returns). So if the strategic hedge ratio is zero or
We show the factor returns starting with the 100%, there may be an off-the-shelf index available.
first month for which all three are available, which is For ratios other than zero or 100%, however, it may
September 2000. For additional information, please be necessary to create (or have an index vendor
see https://gm.db.com/about/disclaimer.html create) a customized currency benchmark, which
21
Net currency exposure is defined as the exposure is a weighted combination of unhedged and fully
from the underlying asset combined with the hedged currency indices.
manager’s hedging. 29
Ideally, the same spot exchange rates should be used
22
For example, a 100% limit would mean that to value both the live portfolio and the benchmark.
hedging activity is limited to the amount of
underlying foreign assets.
49
FIRSTQUADRANT.COM
Currency Hedging Handbook CONCLUSION
Model, backtested or simulated performance presented in this paper and further described below are for illustrative
purposes and are not a representation of strategies currently managed by First Quadrant, L.P. and are provided solely
for conceptual discussion only; therefore no fees are discussed or illustrated within this paper. Results from any live
implementation of strategies discussed would in actuality be reduced by fees charged against an account deploying
the strategy. Model, backtested, or simulated performance is no guarantee of the future results in a live portfolio
using the strategy. Potential for profit is accompanied by possibility of loss. Hypothetical or simulated performance
results have certain inherent limitations. Unlike an actual performance record, simulated results do not represent
actual trading. Simulated trading programs in general are also subject to the fact that they are designed with the
benefit of hindsight. Further, backtesting allows the security selection methodology to be adjusted until past returns
are maximized. No representation is being made that any account will or is likely to achieve profits or losses similar
to those shown. Unless otherwise noted, performance returns for one year or longer are annualized. Performance
returns for periods of less than one year are for the period reported. Reinvestment of earnings was assumed. The
simulated performance used in this presentation may differ from live performance experienced using the same
strategies for a variety of reasons such as: The simulations assume that the strategy guidelines are constant
through the life of the portfolio, whereas, the guidelines for live portfolios may change over the life of each portfolio;
the simulations assume zero transaction cost whereas live portfolio transaction costs will be variable; dependent
on market conditions such as liquidity and portfolio size, the types of instruments traded within the simulations
may not have been permissible in a live portfolio; etc. Details specific to the simulations: Global ex-US equities
includes simulated returns for the following development market countries: Australia, Austria, Belgium, Canada,
Denmark, Finland, France, Germany, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Spain, Sweden,
Switzerland, and the United Kingdom. The unhedged returns for each country is a simulation of the MSCI World
ex-base country measured (not hedged) in the base country’s currency, where the country weights are rebalanced
on a monthly basis. The hedged returns for each country is a simulation of MSCI World ex-base country hedged
back to the base country’s currency, where the country weights are rebalanced on a monthly basis. The hedges are
established with currency forward contracts on each respective currency and adjusted monthly on a per currency
basis. Due to available index and hedging data, start dates of data for Finland and New Zealand is January 1988, for
Norway is March 1984 and for Switzerland is February 1980. Before 1999, we used the average of all the “legacy”
EMU countries as a synthetic EMU country in the dataset. Global ex-US bonds: includes simulated returns for the
following development market countries: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany,
Ireland, Italy, Japan, the Netherlands, Norway, Spain, Sweden, Switzerland, and the United Kingdom. The unhedged
returns for each country is a simulation of the Citi World Government Bond Index ex-base country measured (not
hedged) in the base country’s currency, where the country weights are rebalanced on a monthly basis. The hedged
returns for each country is a simulation of Citi World Government Bond Index ex-base country hedged back to the
base country’s currency, where the country weights are rebalanced on a monthly basis. The hedges are established
with currency forward contracts on each respective currency and adjusted monthly on a per currency basis. Due to
available index and hedging data, start dates of data for Finland is May 1988, for Norway is February 1985 and for
Switzerland is February 1980. US Bonds: Includes simulated returns for the United States.
For index definitions and trademark language used in this handbook, please visit https://www.firstquadrant.com/
index-definitions for further information.
50
FIRSTQUADRANT.COM
This material is for your private information. The views expressed are the views of First Quadrant,
L.P. only are subject to change based on market and other conditions. All material has been
obtained from sources believed to be reliable, but its accuracy is not guaranteed.
FIRST QUADRANT, L.P. | 800 E. COLORADO BLVD. SUITE 900, PASADENA, CALIFORNIA 91101
MARKETING SERVICES INFO@FIRSTQUADRANT.COM | OFFICE 626 683 4223 | WEB FIRSTQUADRANT.COM
Copyright © by First Quadrant, LP, 2017, all rights reserved.

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CURRENCY HEDGING

PAUL GOLDWHITE, CFA

Past or simulated performance is no guarantee of future results.

FOR INSTITUTIONAL USE ONLY. FIRSTQUADRANT.COM

In establishing a currency policy, investors should address two key

The second key question is whether currency exposure should be man-

Currency risk is a significant source of unrewarded risk for many investors.

If mitigated, currency risk can be redeployed into better return-seeking

Investors should adopt a currency policy addressing two main questions:

The Currency Hedging Handbook is a in foreign assets because unhedged currency

Non-US developed bonds of investments. We address two main

Implementation and monitoring an experienced currency overlay manager

CHAPTER 1 requires deliberate action on their part and

TABLE 01 - COMPARING ASSET CLASS VOLATILITY UNHEDGED VERSUS FULLY HEDGED

Unhedged Fully Unhedged Minus Unhedged Compared

Global ex-US equities 17.2% 14.6% 2.6% 18%

Global ex-US bonds 10.8% 4.8% 5.9% 122%

EM equities 18.3% 15.7% 2.5% 16%

EM bonds 10.9% 2.7% 8.3% 308%

Panel B: Maximum Drawdown

Global ex-US equities -75.4% -64.9% — —

Global ex-US bonds -19.0% -9.7% — —

EM equities -65.1% -57.8% — —

EM bonds -34.0% -2.3% — —

Data are annualized standard deviation of monthly returns.

Sources: First Quadrant, L.P., Datastream

Risk reduction from hedging as a function of foreign

Figure 01: Risk reduction from hedging as a function of foreignequity allocation

Source: First Quadrant, L.P., Datastream

Risk reduction from hedging, standard deviation

increasing allocations to international There are also fundamental reasons

Figure 02: Rolling 36 month FX volatility

Rolling 36-month FX volatility

Sources: First Quadrant, L.P., Datastream

FIGURE 03 - GLOBAL ECONOMIC POLICY UNCERTAINTY TIME SERIES

CHAPTER 2 TO PROFIT FROM SUCH CURRENCY

FX hedging using forward exchange traders refer to the difference

FIGURE 04 - RETURN OF FOREIGN CURRENCY BASKET FOR US DOLLAR

Sources: First Quadrant, L.P., Datastream

difference is highly dependent on the own foreign currency exposures, which

2016. 9 Data are annualized to facilitate TABLE 02 - FX VOLATILITY FOR DIFFERENT

0.4 Rolling 36-month FX correlation

Sources: First Quadrant, L.P., Datastream

Fig 05: FX correlation and volatility difference

Sources: First Quadrant, L.P., Datastream

Results The exact result from the inputs in Table

TABLE 04 - PROS AND CONS OF DIFFERENT HEDGE RATIOS

Hedge Pros Cons

50% 80% of the improvement in return/risk; Transactions costs; hedging infrastructure

75% Optimal: maximizes return/risk; Transactions costs; hedging infrastructure

100% Close to optimal; minimizes risk; Transactions costs; hedging infrastructure

FIGURE 08 - OPTIMAL HEDGE RATIOS FOR DIFFERENT OBJECTIVES

Sources: First Quadrant, L.P., Datastream

Exhibit 12: FX correlation and volatility difference - bonds

Sources: First Quadrant, L.P., Datastream

Japan 87% 96% Emerging markets

CHAPTER 3 (or risk-adjusted return) from their

FIGURE 10 - WORLD CURRENCY TRADE IT WOULD SEEM, HOWEVER, THAT

Types of active management

Currency Factors in Brief is needed to entice investors to hold

FIGURE 11 - ROLLING 3-YEAR EXCESS RETURN

FIGURE 12 - ROLLING 3-YEAR INFORMATION RATIO

TABLE 08 - UNIVERSE OF CURRENCY MANAGERS, 5-YEAR TRACK RECORDS