How Hedging Can Protect Your International Assets
Interest rate differentials clearly have an important part to play in determining exchange rates, at least in the short to medium term, and further rate rises over the coming months could push sterling to even greater heights in foreign exchange markets. If that does turn out to be the case, it may not only be against current weak currencies such as the Japanese yen, Swiss franc or US dollar that we see sterling strengthening. It might also have an impact on some of the stronger ones, or at least those perceived to be stronger, such as the euro, the Australian dollar and some Asian currencies.
Such an eventuality could have a significant impact on companies and investors with high levels of overseas assets and liabilities. For these groups, exchange rate trends will not only affect the value of the assets themselves, it will also influence the levels of income they produce.
Fortunately, there are specific techniques which can be used to hedge these risks and, what is particularly attractive about these tools is the fact that they are currently relatively inexpensive. This is due to the compression in interest rate spreads in most areas of the world – exceptions include New Zealand and Japan, which are at the high and low ends of the interest rate spectrum – as well as the recent downward trend in volatility if options are used. The current high levels of UK interest rates mean that investors are being paid to hedge exposure back to sterling against a range of currencies.
The mechanics of this hedging technique and its advantages for investors are best illustrated by considering their impact in a case where foreign exchange forward contracts are used with a specialist passive overlay manager as a way to hedge multi-currency exposures.
In this instance, we would assume that the company has a range of international assets and is risk averse. In such circumstances, there are benefits of running these passive hedging and overlay strategies with a specialist manager. In the very long run hedged and un-hedged returns are expected to be similar. However, on a hedged basis, the standard deviation of returns (i.e. the risk) is much lower. Therefore, on a risk-adjusted return basis, hedging international assets is deemed to be an optimal asset allocation decision.
Among the particular advantages of this system is the fact that foreign exchange (FX) and counterpart risk are managed and reported centrally. These specialist dealing and implementation arrangements, together with the development of key relationships, give access to quality pricing and information, as well as advisory services. The benefit of this is that it affords investors the ability to obtain the best available pricing in forward and options markets. Centralising the process should reduce overall transaction costs, as it should enable the investor to obtain better prices than would be available if they were to make their own arrangements.
This approach is likely to offer other potential cost savings such as a reduction in the management fee, although the exact details of this will vary according to the precise mandate requirements. Typically this would not be more than five basis points. With spreads in the market being minimal, the main costs will be associated with the set up and ongoing management of the process, specifically the expenditure incurred in areas such as personnel, systems, legal, custodial and reporting. Another benefit of hedging in this way is that it ensures all activities comply with forthcoming regulatory requirements such as MiFID, which will come into effect on 1 November this year.
In order to ensure the overlay can be maintained within predetermined parameters, it is critical to ensure that the underlying asset positions are stated with clarity and accuracy. Clearly, it is essential to maintain close consultation between the client and custodian to ensure the content of reports is in line with agreed guidelines and the timescales to be achieved.
The parties must agree whether the overlay is to be managed against the published benchmark or actual asset and liability exposures, as well as determining the mechanisms of informing the manager of the underlying positions.
They should also consult on the nature, frequency and content of rebalancing. For example, it is important to reach agreement at the outset on whether rebalancing is required weekly, monthly or quarterly. Weekly rebalancing is widely regarded as the optimum frequency, but for some clients, monthly intervals may be more appropriate if the rebalancing coincides with updates to the benchmark or the underlying assets. As weekly rebalancing increases the frequency of trading and hence the cost of the hedging programme – more frequent rebalancing entails higher trading costs – the forward currency positions are often run on a monthly maturity cycle.
The following illustration shows the impact of monthly rollovers with one, two and three month duration. This approach helps spread the rollover funding and reinvestment risk to manageable levels and can also increase the likelihood of avoiding event risk on any specific rollover date. This method produced a two month average term, which will reduce the associated legal and administration requirements. If the fund or client exposures are to grow, it would be necessary to adjust the value of the maturing forward contracts by a similar amount over time. After the initial combination of one-, two- and three-month rollovers is completed, further rollovers with a three-month timescale are made in order to maintain the average maturity duration.
A hedging ratio range of 98-102% is considered appropriate for a diversified set of international assets, as most currencies are currently experiencing relatively low volatility. One particular attraction of this is that it does not involve the same costs that would arise from high volumes of rebalancing transactions. It is possible for a company to set other tolerance ranges of hedge ratios to match any alternative requirements. In these circumstances, it is most appropriate that the hedge ratio, which can be defined as the value of non-base currency assets against the value of currency hedges, should be monitored daily.
If the assets in question are international bonds, then significant unrealised and realised cashflows can have a material impact on the duration of the bond performance. The duration of cash is zero. As a result, any unrealised profit generated by the currency hedges can reduce the duration of the bond holdings in a fund. By contrast, any losses in the currency hedges will have the reverse effect – they will increase the fund’s duration. This is because a negative cash position effectively increases the proportion of assets in the portfolio that have a non-zero duration. This duration effect is unintentional and has to be managed carefully. If the duration is higher than intended, this will increase exposure to adverse price movements in the bond portfolio.
To operate efficiently, the hedging process must be accompanied by a system of communication that is effective and ensures the clarity of information flows, particularly when all of the assets in a portfolio are not controlled by a single manager.
The risk of higher inflation, the impact of events such as the sub-prime mortgage collapse in the US and the recent equity market sell off underline the volatility of all asset groups at present. Currency is no exception, but hedging offers the tool to offset this risk. What makes it particularly attractive is that it can be achieved at a limited cost.