Strategic Decisions in Currency Management: The IPS

For many investors, currency management—more specifically, currency risk—offers a potential for excess returns, or the potential for a loss on their investment. There's a wide range of opinions and emotions on currencies. So what should determine your response to currency management?

Not quite. The asset manager needs to be able to implement and execute the strategy.

No. Even if the asset manager can trade currencies for a profit, the client may oppose such action.

Indeed! It's pretty straightforward: given the various opinions on currencies, both the asset manager and client must feel comfortable developing a currency risk strategy. If the client prefers taking currency risk and the manager does not, then the client may be better off finding an asset manager who believes in taking currency risk. So really, it comes down to the beliefs regarding currency risk.

For example, some investors believe that currency markets are efficient in that the moves of Currency A versus Currency B offset each other, which basically results in a zero-sum game. That means there's really nothing to gain by hedging or speculating in currency trading. So for this mindset, what does currency trading and hedging result in?

No. Currency trading and hedging isn't a valuable strategy in an efficient market.

Not quite. More positions that offset each other in an efficient market shouldn't result in more risk.

That's right! Trading and hedging currency will only result in lower returns due to trading costs, so there's really no reason to attempt any currency management. On the other end of the spectrum lie investors who believe that currency management represents an opportunity to earn excess short-term returns through pricing inefficiencies.

These pricing inefficiencies result from inexperienced traders, traders managing international capital and trade flows, and market participants that aren't motivated by profit. Which of the following entities wouldn't be motivated by profits?

Yes! Central banks are in charge of keeping their currencies "pegged" to other currencies, so there's a natural trading rhythm that develops to ensure that the peg is maintained. This consistent presence, along with uninformed retail investors and traders managing capital flows, allows active currency traders to potentially generate alpha through currency management trading. So when it comes down to it, there are many viewpoints on how and when to engage currency management.

Not quite. Investment banks still can run currency trading units for profit, and many do.

No. The experienced retail trader will definitely be looking for profits.

But regardless of the viewpoints, clients and asset managers must work together to utilize the proper strategy that's selected. This is where proper guidelines can be put in place to help both the investor and the asset manager. These guidelines will dictate the degree of discretionary authority given to currency management, the benchmark used to measure the currency exposure, and the limits on trading policies and tools that can be used. Where would you go to find these guidelines?

No. Brokerage restrictions will provide some limitations, but these restrictions don't take into account various client concerns.

Exactly. It's the client's investment policy statement that will bring together the general objectives, risk tolerance, time horizon, liquidity needs, and benchmark for return evaluation. It's also going to spell out the specifics on currency management, like the target proportion of currency exposure, the range of active management around this exposure, the frequency of hedge rebalancing, the currency benchmark to be used, and the hedging tools permitted, like the use of leverage, derivatives, and short positions. Overall, the IPS is going to be the ultimate guide to currency management.

Not quite. That will help guide the implementation of the strategy, but it's not going to provide a complete picture.

To sum it up: [[summary]]

The client's personal opinion

The asset manager's resources and expertise

A comprehensive approach involving the client's needs and manager expertise

Diversified asset allocation

More risk through extra positions

Lower returns through trading costs

Central bank

Investment bank

Experienced retail trader

The brokerage account restrictions

The client's investment policy statement

The investment firm's policies and procedures

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