Objectives of Active Currency Management
Passive Currency Management Foreign Currency Return Gain Unhedged 50% hedged Foreign currency Foreign currency appreciation depreciation Fully hedged Unhedged: accept return volatility as trade-off for diversification Fully hedged: accept cash flow volatility as trade-off for zero return volatility Partial hedge: used to target strategic allocation to foreign Loss currency at the total portfolio level For illustration purposes only
Dynamic Currency Management Create asymmetric outcome Foreign Currency Return Gain Unhedged Dynamic Hedge: reduces foreign currency exposure relative Dynamic hedge to passive target Objective: to floor or limit the cost of foreign currency depreciation 50% hedged Foreign currency Foreign currency depreciation appreciation Fully hedged Gain relative to passive Dynamic Hedge: increases foreign currency exposure relative to passive target Objective: to increase capture rate of foreign currency appreciation and reduce negative cash flow Loss For illustration purposes only
Dynamic Currency Management Why would a fund choose a dynamic currency strategy relative to a linear passive strategy? Concerned about higher currency volatility /risk 1 Fund SAA has high allocations to offshore assets 2 Fund SAA has high allocations to illiquid assets 3
Unconstrained Currency Alpha Generate excess returns Foreign Currency Return Gain Unhedged Currency Alpha + Passive hedge Passive hedge Foreign currency Foreign currency appreciation depreciation Fully hedged Unconstrained Currency Alpha: varies both the level and mix of foreign currency exposure Objective: to generate positive excess returns Loss For illustration purposes only
Unconstrained Currency Alpha Why would a fund choose an unconstrained currency alpha strategy relative to simple passive strategy? Not concerned about higher currency volatility or fund liquidity 1 / negative cash flow, want to maximise return opportunity set Currency alpha: is highly capital efficient 2 has low implementation costs is operationally simple 3 Currency alpha returns are uncorrelated to traditional asset returns
Towards the Ideal Currency Outcome Foreign Currency Return Ideal Outcome Gain Unhedged The “Ideal Outcome” is possible by allocating risk to both a dynamic hedge and an unconstrained alpha program Objective: capture all the gains from foreign currency appreciation and reduce the cost of foreign currency 50% hedged depreciation to zero Foreign currency Foreign currency appreciation depreciation Fully hedged Dynamic hedge increases foreign currency exposure to capture gains from appreciation and reduce negative cash flow / decreases foreign currency exposure to limit the cost of foreign currency depreciation by increasing positive cash flow. Allocation to unconstrained alpha increases the overall risk Loss adjusted return with the objective of at least offsetting the cost of asymmetry For illustration purposes only
Towards the Ideal Currency Outcome Foreign Currency Return Ideal Outcome Gain Objective is to get as close to the ideal outcome Higher hedging allocation as possible, but by varying the risk allocation, portfolio preferences may also be satisfied Higher alpha allocation Foreign currency Foreign currency appreciation depreciation Higher dynamic hedging allocation increases the asymmetry and the capture rate of foreign currency gains – the cost of asymmetry can be high Higher alpha allocation increases the overall risk adjusted Loss return from holding foreign currency exposure, by reducing the cost of asymmetry For illustration purposes only
Towards the Ideal Currency Outcome How do you determine the allocation between alpha and asymmetry? Depends on the funds objectives for holding foreign currency exposure at the total portfolio level • If the objective of holding foreign currency is to increase diversification and minimising negative cash flow is important, then allocate more risk to dynamic (asymmetric) hedging • If return generation is the primary objective, then allocate greater risk to unconstrained alpha
Risk Disclosures • Past performance is not indicative of future results. Investment in any strategy involves a risk of loss which may partly be due to exchange rate fluctuations. • The performance results shown, whether net or gross of investment management fees, reflect the reinvestment of dividends and/or income and other earnings. Any gross of fees performance does not include fees and charges and these can have a material detrimental effect on the performance of an investment. • Any target performance aims are not a guarantee, may not be achieved and a capital loss may occur. Strategies which have a higher performance aim generally take more risk to achieve this and so have a greater potential for the returns to be significantly different than expected. • Portfolio holdings are subject to change, for information only and are not investment recommendations.
Risk Disclosures • Currency risk management • Currency hedging techniques aim to eliminate the effects of changes in the exchange rate between the currency of the underlying investments and the base currency (i.e. the reporting currency) of the portfolio. These techniques may not eliminate all the currency risk. • Derivatives may be used to generate returns as well as to reduce costs and/or the overall risk of the portfolio. Using derivatives can involve a higher level of risk. A small movement in the price of an underlying investment may result in a disproportionately large movement in the price of the derivative investment. • Investments in emerging markets can be less liquid and riskier than more developed markets and difficulties in accounting, dealing, settlement and custody may arise. • Where leverage is used through the use of swaps and other derivative instruments, this can increase the overall volatility. Any event that adversely affects the value of an investment would be magnified if leverage is employed by the portfolio and losses would be greater than if leverage were not employed.
Other disclosures
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