Currency Management

Section: Currency Management in Portfolio Construction Estimated study time: 45 minutes Content: Currency management is a significant source of both risk and return for international portfolios. When a domestic investor holds foreign assets, returns are affected by both the asset's local return and the change in the exchange rate between the foreign currency and the domestic currency. Currency overlay managers specialize in managing this foreign exchange exposure either as a separate mandate (hedging asset managers' FX exposure) or as an alpha-generating strategy (taking active currency positions). The hedging decision starts with the question of whether currency exposure should be fully hedged, partially hedged, or left unhedged. Empirically, currency exposure adds substantial volatility to international portfolios over short and medium horizons, while in the long run currencies tend to revert toward purchasing power parity (PPP), reducing the long-term impact. Most institutional investors adopt a strategic hedge ratio — a target percentage of foreign currency exposure to hedge on an ongoing basis — typically between 50% and 100% for currency-sensitive mandates. Forward contracts are the primary hedging instrument. A manager with a foreign currency asset can sell the foreign currency forward (delivering foreign currency, receiving domestic) to lock in today's exchange rate for a future settlement. The all-in cost of hedging is determined by the forward premium or discount, which equals the interest rate differential (covered interest rate parity). If the foreign country has higher short-term interest rates than the domestic country, forward points are negative — the foreign currency trades at a forward discount and hedging "costs" positive carry (i.e., the manager gives up positive carry from the higher foreign rates to remove the currency risk). Dynamic hedging strategies adjust…