By James Wood-Collins, from Pensions & Investments.
Whether they represent developed or emerging economies, currencies can create a substantial element of volatility in a global equity portfolio. This may not be apparent when international stocks represent, say a third of the total but, as that share rises, so does the potential for currency-induced volatility. More alarmingly, sudden currency shocks — such as the dramatic rise in the yen that followed Japan's disastrous earthquake — can leave investors highly exposed.
Currency management: time for a change?
Techniques for handling currency exposure such as hedging through forward contracts have been available to investors for many years. The traditional approach uses a symmetrical offsetting portfolio of forward contracts — a passive form of hedging — that does reduce volatility over time. Even this established approach should be implemented in the light of currency management best practices. These practices apply to four key areas:
Pricing or best execution.
Any pension fund engaged in currency hedging should ask the institution responsible what safeguards are in place to ensure best execution. Elsewhere, in the U.K. for example, passive currency programs have often been handed off to the plan custodian but recent lawsuits by several state pension plans in the U.S. alleging that custodian banks overcharged in routine foreign exchange transactions have raised serious doubts as to whether custodians should be entrusted with hedging mandates.
Counterparty diversification.
The most efficient and most liquid instrument for hedging currency exposure is the forward contract, traded over the counter. Assuming that forward contracts continue to trade in this way (provisions in the Dodd-Frank Act may subject them to centralized counterparty clearing, raising the cost of hedging), pension funds need to know who their counterparties are and how many they have. If the fund has a mark-to-market currency loss in dollar terms offset by hedges that are “in the money,” it needs to be sure the hedges are widely diversified, minimizing counterparty credit exposure.
Program design and efficiency.
Hedging is intended to act as a proportional offset to the underlying currencies, typically representing between 50% and 75% of total exposure (the “hedge ratio”). Only very rarely does it approach 100% because there is no linear decrease in volatility as the hedge is increased. To illustrate a traditional program, take a situation where the U.S. dollar is weakening: a U.S. pension plan will have a mark-to-market currency gain but it also has forward contracts that mature with an offsetting cost. The market gain is unrealized but cash payments on the contracts have to be met.
Cash flow management.
These payments may be relatively small, year to year, and they may be offset by contracts realizing a gain. However, as indicated earlier, very large currency movements can occur that might necessitate payments reaching 10% to 15% of the total equity program covered, according to research by Record Currency Management. This carries more serious implications for the fund's cash management. Because pension plans typically do not hold large cash balances, securities might have to be sold. While this discrepancy cannot be eliminated in a passive program, the program can be designed to minimize the burden placed on the plan.
Consider a more dynamic approach
There is an alternative to the traditional hedging technique, one that is asymmetric in nature and executed in an active manner rather than passively. Active, or dynamic, hedging is any hedging activity that involves discretion to deviate from the benchmark hedge ratio. Specialist currency managers who take on dynamic hedging mandates almost always have a formal investment process, and operate more or less systematic techniques designed to exploit inefficiencies — such as momentum, or mean reversion — which they have identified in the market. These strategies permit payments to a pension plan through hedging when foreign currencies weaken but reduce the hedging program when these currencies strengthen, allowing the plan to benefit without meeting large forward contract costs. This approach is analogous to insurance, offering U.S. investors the benefit from foreign currencies strengthening against the U.S. dollar while maintaining some protection against periods of weakness.
As U.S. pension plans continue to expand their horizons away from home and pursue opportunities in global equity markets, the issue of effective currency management becomes ever more critical. This is especially true now that investor appetite for emerging market equities has added a wide range of underlying currencies to the mix. In this climate, plan sponsors need as much thought and flexibility in their hedging programs as they can possibly muster.
James Wood-Collins is CEO of Record Currency Management, a specialist currency management firm based in the U.K.
Read more: http://www.pionline.com/article/20110413/REG/110419974#ixzz1JjL8XJIb
Sovereign Investor: The old adage is that there isn't value to be had from trying to manage currency exposures in a global portfolio. Agree? Disagree? Is there evidence that custodian banks overcharge for routine FX services? How can this be controlled?
No comments:
Post a Comment