Currency Overlay: A Practical Guide, Second Edition

523 Pages·2011·13.396 MB·English

by  Hai Xin

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New sections provide:
• Up-to-date assessments of carry and trend-
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• Practical choices for passive overlay,
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active overlay and currency pure alpha; a
• New approaches to emerging market i X
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• Reasons behind the increasing use of
currency beta indexes;
• Detailed discussion on the concept and
practice of alpha-beta separation; and
• New overviews of markets, participants
and legal documents
PEFC Certified
This book has been
produced entirely from
sustainable papers that
are accredited as PEFC
compliant.
www.pefc.org
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Currency Overlay
Second Edition
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Currency Overlay: A Practical Guide
Second Edition
by Hai Xin
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Published by Risk Books, a Division of Incisive Financial Publishing Ltd
Haymarket House
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London SW1Y 4RX
Tel: + 44 (0)207 484 9700
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E-mail: [email protected]
Sites: www.riskbooks.com
www.incisivemedia.com
© 2011 Incisive Media Investments Ltd.
ISBN 978 1 906348 54 0
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
Publisher: Nick Carver
Comissioning Editor: Lucie Carter & Jade Mitchell
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Typeset by Tricolour Design, Sudbury, Suffolk
Printed and bound in the UK by PrintonDemand-Worldwide
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Contents
List of Figures xv
List of Tables xix
Foreword xxi
About the Author xxiii
Preface to Second Edition xxv
Acknowledgements xxxi
1 InTroducTIon To currEncy rISk MAnAgEMEnT
And ovErLAy 1
1.1 A brief history of modern currencies 2
1.2 Some stylised facts about the foreign-exchange market 5
1.2.1 Who uses it and why 5
1.2.2 Types of trade, transparency and transaction cost 6
1.2.3 Market size, major currencies and concentration 8
1.2.4 Recent trends in OTC and exchange-traded currency derivatives 12
1.3 defining currency returns 13
1.3.1 Absolute return when underlying investment return is certain 15
1.3.2 Selecting a suitable return measure 18
1.3.3 Absolute return when underlying investment return is uncertain 19
1.3.4 Relative return 22
1.3.5 Ex ante versus ex post return 23
1.3.6 Nominal return versus real return 24
1.3.7 Unhedged return, hedged return and local-currency return 25
1.4 A simple descriptive tour of currency risks 26
1.4.1 Short-term versus long-term contribution 26
1.4.2 Correlation 35
1.4.3 Stock prices and currency fluctuations 36
1.4.4 Bond prices and currency fluctuations 38
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CURRENCY OVERLAY – SECOND EDITION
1.4.5 A word of caution for unsuspecting readers of statistics 39
1.5 What is special about currencies? 40
1.5.1 “Currency trading is a zero-sum game” 41
1.5.2 “Currency movements represent random walks and are unpredictable” 42
1.5.3 “Foreign exchange is not a separate asset class” 43
1.5.4 “Currency is part of global diversification, but hedging reduces di-
versification benefit” 45
1.5.5 “Unlike equity or bonds, currency does not attract a risk premium” 46
1.5.6 “Currency market is efficient” 47
1.5.7 Forward bias (uncovered interest-rate parity, or carry trade) 48
1.5.8 Autocorrelation (momentum, trends and countertrends) 50
1.5.9 Purchasing-power parity (PPP) prevails in the long run 50
1.5.10 Summary 51
1.6 FX risk management and currency overlay 52
1.6.1 Continued interest in foreign-exchange risk management 52
1.6.2 The growing global market and its consequences for investors 55
1.6.3 Should currency risk be hedged? Some questions and answers 56
1.6.4 Survey of studies on currency hedging 59
1.6.5 Currency overlay: what it is and what it is not 69
Appendix 1A: uncovered interest rate arbitrage 70
Appendix 1B: The correlation triangle 71
Appendix 1c: Forecast, forward and no-arbitrage price 72
2 currEncy-ovErLAy MAnAgEMEnT 77
2.1 Introduction 77
2.2 origins and development of currency overlay 78
2.3 different approaches to managing currency risks 81
2.3.1 A do-nothing approach 81
2.3.2 Active versus passive versus dynamic hedging 82
2.3.2.1 A passive hedging approach 83
2.3.2.2 An active hedging approach 84
2.3.2.3 A dynamic hedging approach 85
2.3.3 Currency-pure-alpha approach 86
2.4 definitions and merits of currency overlay 86
2.4.1 A working definition 88
2.4.2 The difference between currency overlay and currency hedging 90
2.4.3 Different types of currency overlay 91
2.4.4 Risk separation and risk responsibility 93
2.4.5 Competency-based approach 94
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CONTENTS
2.4.6 Advantages and disadvantages of employing currency overlay 96
2.4.6.1 Advantages 96
2.4.6.2 Disadvantages 97
2.5 What an overlay process looks like in practice 97
2.5.1 The process of defining a currency overlay 98
2.5.2 A currency overlay laid upon different asset classes 98
2.5.3 The information flow between different parties 101
2.5.4 A daily flowchart for a currency-overlay manager 102
2.5.5 Decision making within an active currency-overlay manager 104
2.6 Trading styles for active overlay and currency pure alpha 104
2.6.1 Fundamental-quantitative: the failure of macroeconomics 106
2.6.2 Technical-discretionary: gradually replaced by machines 107
2.6.3 Fundamental-discretionary: on the wane but back with a vengeance 108
2.6.4 Technical-quantitative: gaining in importance but suffered badly
during crisis 108
2.7 overview on the main parties involved in the currency-overlay
business 109
2.7.1 Currency-overlay managers 109
2.7.1.1 Internal and external currency-overlay managers 109
2.7.1.2 Overview 110
2.7.1.3 Major currency-overlay managers 112
2.7.1.4 Services provided by currency-overlay managers 113
2.7.1.5 Return-enhancement versus risk-control objectives 114
2.7.1.6 AUM and AUME figures 115
2.7.1.7 Trading styles 117
2.7.1.8 Recent changes 118
2.7.2 End-users of currency overlay 120
2.7.3 Counterparty banks and prime brokers 121
2.7.4 Custodians 123
2.7.5 Consultants 124
2.8 Historical performance of currency-overlay programmes 124
2.8.1 Foreign-exchange-only performance databases and indexes 126
2.8.2 Two earlier studies of manager performance in 2000 127
2.8.3 An analysis of the Parker FX Index 128
2.8.4 Problems with performance-based benchmarks 135
2.8.5 New evidence: 2003–2010 136
2.9 outsourcing currency management 140
2.9.1 Legal documents for an outsourced currency-overlay programme 141
2.9.1.1 Investment management agreement 141
2.9.1.2 ISDA and exceptions 143
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CURRENCY OVERLAY – SECOND EDITION
2.9.1.3 Prime brokerage agreement 144
2.9.2 Cost of currency overlay 144
2.9.2.1 Management fees and performance fees 144
2.9.2.2 Transaction costs 146
2.9.2.3 Opportunity cost 147
2.9.2.4 Forward premium/discount 148
2.9.3 Evaluating the service 149
2.9.3.1 Track record 149
2.9.3.2 The organisation 149
2.9.3.3 Research 149
2.9.3.4 Processes 150
2.10 Summary 150
Appendix 2A: Main players in the currency-overlay market 151
3 currEncy ovErLAy: SoME PrAcTIcAL cHoIcES 155
3.1 Introduction 155
3.2 choices for overall currency management policy 156
3.2.1 Active or passive overlay approach 156
3.2.2 Active currency overlay or curreny-pure-alpha programme 158
3.2.3 Running a passive overlay combined with a curreny-pure-alpha
programme 159
3.2.4 Internal or external currency-overlay programme 160
3.2.5 Using several managers 160
3.2.6 Choice of instruments 161
3.2.6.1 The use of derivatives 162
3.2.6.2 Forwards versus futures 162
3.2.6.3 Foreign exchange swaps 163
3.2.6.4 Non-deliverable forwards 164
3.2.6.5 Use of currency options 165
3.2.6.6 Other types of innovative instruments 166
3.2.7 Risk constraints 166
3.2.7.1 “No net short sale”, “no leverage” and other position limits 166
3.2.7.2 Volatility limit and tracking-error limit 168
3.2.7.3 Leverage limit 168
3.2.7.4 Value-at-risk limit 169
3.2.7.5 Stop-loss limit and maximum drawdown limit 170
3.2.7.6 Tolerance range around hedge ratio 170
3.2.7.7 Different restrictions for different types of currency programmes 171
3.2.8 Portion of portfolio allocated to foreign assets 172
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CONTENTS
3.3 choices for passive overlay 172
3.3.1 Benchmark hedge ratio 172
3.3.2 Same or different benchmark hedge ratio for bonds and equities 175
3.3.3 Hedging benchmark weights or actual exposures? 175
3.3.3.1 Hedging actual exposure 176
3.3.3.2 Hedging benchmark weighting 176
3.3.3.3 Hedging to benchmark-neutral 177
3.3.4 Hedging horizon 177
3.3.5 Instrument tenor 178
3.3.6 Rebalancing frequency and tolerance band 182
3.3.7 Hedging cash account 183
3.3.8 Rollover date 186
3.3.9 Cross-hedging 186
3.3.10 Proxy hedging 187
3.3.11 Currency-fixing arrangements and WM/Reuters rates 188
3.3.12 Reporting 189
3.4 choices for active overlay 190
3.4.1 Benchmark hedge ratio 190
3.4.2 Symmetry of constraints 190
3.4.3 Reporting 192
3.5 choices for pure alpha 193
3.5.1 Funded or unfunded 193
3.5.2 Using listed vehicles 194
3.5.3 Setting a risk budget 195
3.5.4 Target information ratios and target returns 195
3.5.5 Reporting 195
3.6 overlay and prime brokerage 196
4 FX rESEArcH And cHoIcE oF currEncy MAnAgEMEnT
STyLES 201
4.1 Introduction 201
4.2 Models based on purchasing-power parity 203
4.2.1 Law of one price 203
4.2.2 Absolute PPP 204
4.2.3 Problems with absolute PPP theory 205
4.2.4 Relative PPP 205
4.2.5 Empirical testing 205
4.2.6 Examples of application 207
4.2.7 Other types of fair-value models 208
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