FX Overlay
How do big players think and act when hedging equity, currency, commodity or interest rate positions?
In principle, exchanging amounts in different currencies is a zero-sum game. The reason that some participants in the foreign exchange market actively manage their foreign currency positions makes it possible for some of them to operate above the zero bound, but at the expense of other participants.
The market
The view of the foreign exchange market has increasingly changed in recent years. It is no longer just seen as a by-product of international trading and capital markets, but now also as a form of investment. Fund and hedge fund managers, whose strategies often do not work out due to the lack of volatility on the stock markets, have moved to form their own foreign exchange strategies and launched their own currency funds. Funds are becoming increasingly sophisticated in their use of currency vehicles to increase their profits. At least that is what they are trying to do, because it is almost impossible to predict the foreign exchange market, as there are a myriad of parameters that cannot be calculated sufficiently, e.g. human logic.
The participants
A glance at the fund publications shows that there is no doubt that the number of funds investing in currencies is steadily increasing. However, most asset managers, treasurers and cash managers trade currencies with a transactional background. This means that behind a trade there is usually a "real" transaction with goods or assets, such as shares. It is therefore not purely a profit motive, but rather a hedge or a simple switch from one currency to another because it is needed today or in the future. The optimization idea behind these hedges is often directed towards negotiating better prices for the exchange. This is done by the larger market participants through special electronic broker programs to which several banks are connected, with the bank offering the best price being awarded the contract.
The decision of the bank or institutional market participant
The sense of such programs can be debated. On the one hand, it is not difficult from the bank's point of view to calculate the break-even point for a market participant, i.e. the customer. On the other hand, however, the question of timing arises. Should the order be executed at 11:00:00, 11:00:10 or 11:01:00 and where will the price be? This random factor cannot be calculated and the range within a minute in the foreign exchange market can be enormous, relative to haggling for one or two pips.
Winners and losers
All market participants agree on one thing: currency risk is always present unless it has been hedged naturally (i.e. assets vs. capital, income vs. expenses in the same currency and at the same time in the balance sheet). This risk must be recognized and managed. Banks offer institutional clients in particular, especially funds with their enormous resources, tailor-made products to manage the exchange rate risk at the lowest possible cost. However, the market principle of the zero-sum game still applies. The question therefore arises as to who the losers are in this global trading system. In the end, it is all of us in one form or another. Be it through direct losses, lost profits, higher margins on the products we trade or consume on a daily basis. This closes the global circle. Nonetheless, every market participant is trying to get the most out of it. Which in turn leads to the question of where this optimum is and can be determined individually, i.e. how large is the loss tolerance of each individual?
Pension funds that do not actively manage their currency risk and therefore do not hedge it are clearly exposing themselves and thus accepting gains and losses resulting from currency differences. There is therefore a financing issue on the one hand and a portfolio efficiency issue on the other. If companies and pension funds accept these risks so easily, it can be assumed that they are actively managed in another part of the portfolio in order to return to the "safe" profit zone. Most companies and funds pursue a middle-of-the-road strategy, i.e. they hedge some of the risks and try to contain the volatility caused by fluctuations in value due to currency differences.
In an attempt to secure and expand earnings, pension funds are continuously increasing the proportion of shares in foreign currencies. However, this also increases their currency risk. This, together with the active management of investment vehicles, is the main reason for the rapid expansion of the cash manager profession. In earlier times, these tasks were outsourced to specialized external companies, but in the context of ever-increasing internationalization, the currency risk is also increasing. Currency mergers, such as the euro, are the absolute exception that contain these risks.
Achieving the optimum, regardless of the market participant's intentions.
A distinction must be made between
- Trading, production and service companies (the companies) and
- institutional investors.
The former, as already mentioned at the beginning, try to contain their risks, while the latter try to generate profits with this risk. However, they both have one thing in common: getting the most out of the foreign exchange market for their own purposes.
Currency overlay
In a strategic and tactical investment process, the foreign exchange market can be viewed as a separate asset class - and currency risks can be reduced to expected portfolio risks. Active currency overlay positions are generally uncorrelated to bond and equity positions. Successful active currency management increases portfolio returns and should be seen as a natural part of a cash flow alpha process. A disciplined "style-rotation-strategy" has gained acceptance among many overlay experts. This is based on continuous macro, political and money flow analysis across the G7 currencies and is combined with technical analysis tools. The "trading style" itself is divided into the following areas:
- Momentum
- Range
- Volatility
Momentum Trading
Momentum trading is a bridge-building style, insofar as it takes into account a basic forecast for medium to long-term movements in the foreign exchange market. This role also forms the basis for range trading - the most frequently used style of foreign exchange trading - by identifying maximum and minimum ranges in order to execute foreign exchange transactions in accordance with risk-return principles.
Range Trading
In addition, range trading analyzes the so-called underlying channeling patterns (range), which result from the current and predominant paid price scenarios. The clear objective is to stay within this range as long as possible in order to maximize the value creation potential of this style.
Volatility (Vega) Trading
A final switch to volatility trading occurs when a previously applied range is exceeded. Either to one side or the other and without a clearly recognizable continuation of this overshoot. Volatility trading is implemented with currency options, which are sold or bought according to the current position. In any case, when volatility trading opportunities are exhausted, there is a logical return to momentum or range trading.
The risk or hedge ratio between 0% and 100% and the underlying currency specified by the client define the proportional amount of absolute currency risk for the respective mandate. This means either an actively or passively managed mandate. Active currency management allows the client to reduce risk and generate return on an international portfolio, whereas the passive currency management approach negates currency risk and focuses on diversifying returns from international investments.
Case study
Finally, a practical example for a client (somewhat older, but the process remains unchanged):
Associated cash flows for the above trades:
In other words, a treasurer with functional currency CHF and the need to reduce his currency risk of USD 7.2m now has the option of offsetting his loss of USD 7.2m x (1.0741 - 1.1871) = - CHF 813,600 against profit. In contrast, the treasurer with investment intentions now earns an annualized gross profit of 28.2% on his USD 25m.
In the case of a currency overlay for currency hedging, we recommend introducing a value at risk control based on best practice risk management in order to adjust the overlay position to the underlying or vice versa. This control could be completed with a so-called "absolute loss amount".