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LM3 Currency Management: An Introduction 2024 Level III Notes © IFT. All rights reserved 1 LM3 Currency Management: An Introduction 1. Introduction .......................................................................................................................................................3 2. Foreign Exchange Concepts .........................................................................................................................3 Spot Markets .....................................................................................................................................................3 Forward Markets.............................................................................................................................................3 FX Swap Markets .............................................................................................................................................4 Currency Options.............................................................................................................................................4 3. Currency Risk and Portfolio Risk and Return .......................................................................................4 Return Decomposition ..................................................................................................................................4 Volatility Decomposition..............................................................................................................................4 4. Strategic Decisions in Currency Management ......................................................................................6 The Investment Policy Statement.............................................................................................................6 The Portfolio Optimization Problem........................................................................................................6 Choice of Currency Exposures....................................................................................................................7 5. Spectrum of Currency Risk Management Strategies ..........................................................................7 Passive Hedging ...............................................................................................................................................8 Discretionary Hedging...................................................................................................................................8 Active Currency Management ....................................................................................................................8 Currency Overlay.............................................................................................................................................9 6. Formulating a Currency Management Program................................................................................ 10 7. Economic Fundamentals, Technical Analysis and the Carry Trade........................................... 10 Active Currency Management Based on Economic Fundamentals........................................... 10 Active Currency Management Based on Technical Analysis ....................................................... 11 Active Currency Management Based on the Carry Trade............................................................. 11 8. Volatility Trading........................................................................................................................................... 12 9. Forward Contracts, FX Swaps, and Currency Options .................................................................... 15 Forward Contracts ....................................................................................................................................... 15 Roll Yield.......................................................................................................................................................... 17 Currency Options.......................................................................................................................................... 19 10. Currency Management Strategies ........................................................................................................ 21 Over-/Under-Hedging Using Forward Contracts............................................................................. 21
LM3 Currency Management: An Introduction 2024 Level III Notes © IFT. All rights reserved 2 Protective Put Using OTC Options ......................................................................................................... 22 Risk Reversal (or Collar)............................................................................................................................ 22 Put Spread....................................................................................................................................................... 22 Seagull Spread ............................................................................................................................................... 22 Exotic Options................................................................................................................................................ 23 Section Summary.......................................................................................................................................... 25 11. Hedging Multiple Foreign Currencies................................................................................................. 25 Cross-Hedges and Macro Hedges........................................................................................................... 26 Minimum Variance Hedge Ratio............................................................................................................. 28 Basis Risk......................................................................................................................................................... 28 12. Currency Management Tools and Strategies: A Summary ......................................................... 28 13. Currency Management for Emerging Market Currencies ........................................................... 32 Special Considerations in Managing Emerging Market Currency Exposures....................... 32 Non-Deliverable Forwards ....................................................................................................................... 32 Summary ............................................................................................................................................................... 33 This document should be read in conjunction with the corresponding reading in the 2024 Level III CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute. Version 1.0
LM3 Currency Management: An Introduction 2024 Level III Notes © IFT. All rights reserved 3 1. Introduction In this reading, we will look at the basic concepts and tools of currency management. For a global portfolio, which can contain many foreign currency denominated assets, effective management of currency risk is the key to achieving superior returns. 2. Foreign Exchange Concepts In the foreign exchange market, less than 40% of the transactions are direct trades in spot markets. The majority of the transactions (more than 60%) take place in FX derivatives markets, and they are for risk management purposes. Spot Markets In professional FX markets, currencies are identified by standard three-letter codes. For example, USD stands for US dollar, and EUR stands for Euro. In the curriculum, exchange rates are quoted using the price/base convention. The price currency is in the numerator and the base currency is in the denominator. The base currency is the currency of which there is one unit. Consider the following exchange rate: USD/EUR = 1.3500. Here USD is the price currency and EUR is the base currency. One EUR can be traded for 1.3500 USD. Instructor’s Note: Some vendors use the base/price convention. To remain consistent with the curriculum these notes will use the price/base convention. The spot exchange rate is typically for T + 2 delivery i.e. the settlement will take place on the second business day after the trade date. Exchange rates are quoted in terms of a bid-offer price. Bid price is the price (in terms of price currency) at which a dealer is willing to buy one unit of the base currency. Offer is the price at which a dealer is willing to sell one unit of the base currency. For example, USD/EUR = 1.1648 / 1.1652. Here the dealer will buy 1 EUR for 1.1648 USD and sell 1 EUR for 1.1652 USD. Forward Markets Forward contracts are transactions with a settlement longer than T + 2. The rate used in forward contracts is called the forward rate. Forward rates are quoted in terms of forward points. Points are simply the difference between the forward exchange rate quote and the spot exchange rate quote. To convert quoted points into a forward rate, divide the number of points by 10,000 and then add the result to the spot rate. For example, if the spot rate is USD/EUR = 1.1649 and the three- month forward points are 25.3, then the three-month USD/EUR forward rate = 1.1649 + (25.3/10,000) = 1.1674. Instructor’s Note: For some currency pairs such as JPY/USD the quoted points need to be divided by 100.
LM3 Currency Management: An Introduction 2024 Level III Notes © IFT. All rights reserved 4 The profit or loss from a forward position in the exchange rate market depends on the type of position in the currency and whether the currency is appreciated or depreciated. A summary of possible outcomes is provided below. Currency appreciates Currency depreciates Long base currency Profit Loss Short base currency Loss Profit FX Swap Markets An FX swap is a simultaneous spot and forward transaction; one leg of the swap is buying the base currency and the other is selling it. FX swaps are used to renew outstanding forward contracts once they mature, to “roll them forward.” A hedge ratio is the ratio of the nominal value of the derivatives contract used to hedge the market value of the hedged asset. Currency Options Currency options are similar to options on other assets (e.g., bonds, equities). The most common options are call and put. However, in addition to these vanilla (plain) options, FX markets also have exotic options. Exotic options have a variety of features as compared to vanilla options, which makes them flexible tools for risk management. 3. Currency Risk and Portfolio Risk and Return Return Decomposition The return on a foreign asset (in domestic currency terms), is a combination of the return on the asset in foreign currency terms and the change in the value of the foreign currency (relative to the domestic currency). The returns can be calculated as: RDC = (1 + RFC)(1 + RFX) − 1 For example, suppose that a U.S. investor bought Euro-denominated bonds. The return on the bonds was 10% and EUR appreciated against the dollar by 5%. Then the total return for the U.S. investor is (1 + 10%) (1 + 5%) – 1 = (1.10)(1.05) – 1 = 0.155 = 15.5%. An alternative method to calculate the approximate total return is to simply add the two returns. In our example, the total return would be ≈ 10% + 5% ≈ 15%. Volatility Decomposition As studied in portfolio management at Level I and Level II, the volatility of a two-asset portfolio can be calculated as: σp 2 = σA 2wA 2 + σB 2wB 2 + 2ρwAwBσAσB