Spectrum of Currency Risk Management Strategies

No. The total portfolio should be measured against the risks taken.

Ultimately, currency hedging can be thought of like a spectrum that runs just like investing runs from complete index funds to total alpha generation strategies. So from a currency management perspective, how would you describe a foreign currency portfolio that attempts to closely align with its benchmark?

When it comes to attempting to exceed a benchmark, full-fledged active management is the next step on the currency management spectrum. As the name suggests, active currency management allows the manager to develop directional opinions on exchange rates but still has mandated risk limits. So those mandated risk limits impose restrictions against unlimited speculation and unusually large currency exposures. Why would risk limits still be in place to limit speculation and position sizes?

No. Large, risky positions aren't easy to hedge. You'd need any investment bank to help offset that risk.

Not always. Large, risky currency positions are typically easier to liquidate than most other asset classes, so that's not the primary reason for limitations.

Exactly! Large, risky currency positions can easily put the entire fund at risk due to the nature of quick currency corrections. So active currency management still requires risk limitations, but it also requires—or, better yet, desires—active currency exposures to earn a profit. That's a different approach than discretionary currency management in that the asset manager isn't charged with earning extra returns unless there's a strong conviction. If there's no conviction, then the manager can remain unexposed.

From this limited active currency management stems what's called __currency overlay__, which essentially means that an external third party is responsible for managing the foreign exchange exposure. For some asset managers, a currency overlay program simply means handing off full hedging responsibility, while other times it can mean complete discretion taking risks in predicting future currency movements within certain ranges. But in many cases, a full currency overlay program means that the currency overlay manager is free to take any foreign-exchange position in any currency pair that shows potential for gains. Essentially, it's a foreign-exchange hedge fund position that requires the manager to have opinions on currency pairs. What type of opinion would be required to fully manage currency pairs?

No. Even if your opinion is correct, you need to find another currency that will reflect that opinion correctly.

Right! If the active currency overlay manager is taking risks in a currency pair, the opinion on each currency needs to be a joint opinion so the currency pair reflects both assumptions. The manager will also need opinions on the expected moves in spot rates and the probability of these movements, as well as the expected correlation between future spot rate movements.

No, actually. The asset manager's performance is going to be compared to what the client can earn consistently.

For some organizations, separating the alpha generation of currency overlay from the hedged portfolio makes sense in that it takes advantage of a manager's particular expertise. But this approach only makes sense when the external manager can generate additional alpha or diversification that adds value to the portfolio. So what should the correlation be between the currency overlay fund and the hedged portfolio?

No. That's not going to provide any diversification benefits.

No. That's not going to provide additional value to the portfolio. It will just offset gains or losses.

Exactly! You'd want the foreign currency exposure to have closer to zero correlation than fully positive or fully negative because that way the foreign currency exposure provides diversification and return benefits. So many hedged portfolio managers set a desired correlation between the regular portfolio and the foreign currency portfolio. And since foreign currency strategies can differ significantly, many times funds will use multiple foreign currency managers with different strategies. But you must be certain that each strategy can be accurately measured and evaluated against a proper benchmark that matches the foreign exchange strategy.

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No. The currency opinions need to be consistent.

No. Active management doesn't align with the benchmark. It's all about alpha generation.

That's right! If the portfolio's goal is to align with the benchmark, then it's essentially passive currency management because there's no excess risk-taking outside of the benchmark policies. But this doesn't mean that currency risk is avoided because some benchmarks take active currency risk, and the portfolio may attempt to mimic that risk. Basically, the benchmark sets the positions and allocations for the asset manager and acts like strict rules, so there's no attempt at alpha generation through currency management. Instead, asset managers must focus their efforts on the portfolio exposures to keep them as neutral as possible versus the benchmark. So what's the asset manager going to be focused on?

No. Tactical strategies take some risk at opportune times. Aligning with a benchmark prevents that.

Yes! Tracking errors between the portfolio and the benchmark are the asset manager's primary concern because tracking errors will lead the portfolio's performance to differ from the benchmark. That's why portfolio managers are given flexibility to rebalance the portfolio on a regular schedule, like monthly, to account for the natural drift, or change due to market conditions of the portfolio.

No. There are no excess risk premiums for modeling the benchmark.

No. The portfolio and benchmark standard deviation should match, so that's not the manager's focus.

But for other asset managers, changing market conditions can allow for tactical shifts in portfolio allocations. That's a discretionary currency management strategy, which allows for shifts in currency exposure in relation to ranges based on the benchmark. Typically, these ranges are set as a percentage of the foreign currency's market value. But the asset manager must still be careful because the manager is taking extra risk to generate excess returns. What's the overall portfolio return going to be compared to?

That's right! The discretionary currency management is measured versus the benchmark because that's what the client can earn and what the currency exposure ranges are based on. So the asset manager must attempt to meet or exceed the benchmark over time.

Active

Passive

Tactical

Large, risky positions can be easily hedged

Large, risky positions can be difficult to liquidate

Large, risky positions can risk the solvency of the portfolio

A single opinion on one currency

A joint opinion on both currencies

Multiple opinions on one currency pair

Closer to 0

As close to 1 as possible

As close to -1 as possible

Tracking errors

Excess risk premiums

The portfolio's standard deviation

The benchmark

The excess risk taken

The total expected return of the benchmark and extra currency risk

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