Hedging Multiple Foreign Currencies

A cross hedge (sometimes called a proxy hedge) refers to hedging with an instrument that is not perfectly correlated with the exposure being hedged. Hedging the risk of a diversified U.S. equity portfolio with S&P futures contracts is a cross hedge when the portfolio is not identical to the S&P index portfolio. Cross hedges are generally not necessary … Read more

Currency Management for Emerging Market Currencies

The majority of investable asset value and FX transactions are in the six largest developed market currencies. Transactions in other currencies pose additional challenges because of: higher transaction costs, “high markups” the increased probability of extreme events Examples: Low trading volume leads dealers to charge larger bid/asked spreads. The problem is compounded as the spreads … Read more

Tools of Currency Management

Futures or forward contracts on currencies can be used to obtain full currency hedges, although most institutional investors prefer to use forward contracts because: They can be customized, while futures contracts are standardized. They are available for almost any currency pair, while futures trade in size for only a limited number of currencies. Futures contracts … Read more

Active Strategies/Tactical Decisions

Active Currency Management Based on Economic Fundamentals This approach assumes that, in the long term, currency value will converge to fair value. For example, a fundamental approach may assume purchasing power parity will determine long-run exchange rates. Several factors will impact the eventual path of convergence over the short and intermediate terms. All else equal, … Read more

Strategic Decisions

There are a variety of approaches to currency management, ranging from trying to avoid all currency risk in a portfolio to actively seeking foreign exchange risk in order to manage it and enhance portfolio returns. There is no firm consensus—either among academics or practitioners—about the most effective way to manage currency risk. Some investment managers … Read more

Effects of Currency on Portfolio Risk and Return

Domestic currency or home currency is the currency of the investor (or the currency in which portfolio results are reported and analyzed). Domestic asset is an asset denominated in the investor’s domestic currency. Foreign currency and foreign asset are a currency other that the investor’s domestic currency and an asset denominated in that foreign currency. These are sometimes called the local currency … Read more

FX Concepts

The Price and Base Currencies: The base currency is the denominator of the exchange rate and it is priced in terms of the numerator.  Bid/Asked Rules: Currencies are quoted with a bid/offered or bid/asked price. By convention, the smaller number is written first and the larger number is second. However, both the bid and the asked can be interpreted as the sale of one … Read more

Derivatives on Volatility

With the introduction of volatility futures and variance swaps, many investors now consider volatility an asset class in itself. In particular, long volatility exposure can be an effective hedge against a sell-off in a long equity portfolio, notably during periods of extreme market movements Volatility Futures and Options The best know measure of market volatility … Read more

Managing Equity Risk

Investors can achieve or modify their equity risk exposures using equity swaps and equity forwards and futures. Equity Swaps An equity swap is a derivative contract in which two parties agree to exchange a series of cash flows whereby one party pays a variable series that will be determined by a single stock, a basket … Read more

Managing Currency Exposure

Currency swaps, forwards, and futures can be used to effectively alter currency risk exposures. Currency risk is the risk that the value of a current or future asset (liability) in a foreign currency will decrease (increase) when converted into the domestic currency. Currency Swaps A currency swap is similar to an interest rate swap, but … Read more