Explain the strategic decisions available in managing currency exposure
The idea
The choices form a spectrum. Passive hedging holds a fixed hedge ratio, often 100%, and rebalances to it. Discretionary hedging lets the manager stray within a narrow band to add some value. Active currency management treats currency as a return source with wider limits. A currency overlay hands the exposure to a specialist, for hedging, alpha or both. Placement depends on horizon, asset mix (bonds are hedged more readily than equities), client risk aversion and fear of regret, hedging costs, and whether the client believes currency management adds value. The trap is treating a full hedge as free and riskless: rolling forwards costs money, creates settlement cash flows and forgoes gains when the foreign currency rises.
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- Analyse how exchange rate changes affect the risk and return of a portfolio
- Design a suitable currency management programme in light of market conditions and the portfolio's objectives and constraints
- Contrast active currency approaches that rely on fundamentals-based valuation, technical analysis, carry trades or trading volatility
- Explain how shifts in the drivers of active currency strategies alter tactical positioning
- Explain how hedge ratios are adjusted using currency forwards and foreign exchange swaps
- Explain techniques that cut the cost of hedging and alter the risk and return profile of a portfolio holding foreign-currency assets
- Explain the role of minimum-variance hedge ratios, macro-hedges and cross-hedges for portfolios exposed to several foreign currencies
- Explain the difficulties of managing currency exposure in emerging markets