Currency Risk Management

Translation risk: risk associated with exchanging foreign currency to the domestic one

Translation loss: return in local currency – return in domestic currency

Use direct quote, foreign current is just like “goods”

Return on future = (F_T – F_0)* principal

1. Direct quote
2. Put neg sign if sell

Currency return = % change is spot price

Basis = difference between the spot rate and the future rate at a point in time

Interest rate parity:

Future/Spot (Direct quote)= (1+r_d)/(1+r_f)

If the basis changes (Basis risk), the principals will not be perfectly hedged by the futures.

Hedged return = unhedged return + future gains

= (St*VLt-S0*VL0)/S0*VL0 – (Ft*VL0-F0*VL0)/S0*VL0

Economic Risk: risk associate the return of local asset and exchange rate

Minimum variance hedge ratio h

R(D,u) = alpha + h*R(future)

h = cov(future,R_D_u)/var(future) = hT+hE = 1 + cov(RL, RC)/var(RC)

RL is return in local currency

RC is currency return

So hE is the economic loss

To avoid basis risk, need future with maturity equals to the holding period

If too long, basis may change and face basis risk

If too short, need transaction cost

But series of shot contract can help to adjust closely to the most updated portfolio values

By knowing h, it can help to hedge and the return can be predicted.

Hedging multiple currencies

R(D,u) = alpha + sum(hi*Fi)+error

Currency option

To prevent local currency depreciate, so must be longing put. Together with the unhedged asset, it forms a protective put (equivalent to longing call)

Currency Delta Hedging

Delta = change in option/ change in exchange rate

Option price change per $1 exchange rate change

Delta hedging requires a lot of transaction costs

Option – insurance

Future – hedging

Currency Management Strategies

1. Balanced Mandate (1 manager and follow IPS)
2. Currency Overlay (1 extra manager following IPS for currency exposure)
3. Separate asset allocation (manage separately as an asset with its own guidelines)