One man one vote, but winner takes all
A number of currency managers use a variety of fundamental and technical inputs into their decisions on when to hedge currency risk.
But, how can these sources of insight best be combined? Each factor could be given an equal share in determining the hedge ratio – one man, one vote or an equal allocation strategy. Or, if more factors are pointing up than pointing down, then up may be the direction to go – a winner take all approach or majority allocation strategy.
We’ll examine the results of these varying combinations by using three simple trading rules known to take advantage of inefficiencies and disequilibria in foreign exchange markets. Two are fundamental and one is technical.
o The Big Mac® Index posits that the same good ought to cost the same everywhere in the world. If the mouthful costs £1.90 in London and E2.80 in Frankfurt, and the euro/pound exchange rate is £.61 per euro, then it ought to cost £1.71 in London or E3.11 in Frankfurt. It doesn’t, and the euro is cheap to the pound and prices will converge. Euro based investors should hedge the pound, while pound based investors should leave euro exposures unhedged.
o A Value rule assumes that the forward rate bias will continue to hold and the premiums offered (discounts demanded) on forward contracts will consistently overstate the subsequent rise (fall) in foreign currency spot rates. The implication is to hedge when offered a premium and remain exposed when it would incur a discount. Positive results have been documented1.
o A Momentum rule assumes that currencies will trend rather than mean revert, and will determine hedging levels for period 2 based upon the success of hedging in period 1 – ie, repeat last month’s successful approach. If hedging made money relative to unhedged, then hedge again; if it underperformed, then don’t hedge. Trending behaviour in currency markets has been identified2.
We apply each of these rules to the cap weighted exposures of an international equity portfolio:
o At the beginning of each month for each currency and maintain the position for the month.
o For investors from a USD, GBP, EUR, and JPY base.
The results are measured against a 50% hedged benchmark and the excess return is detailed.
Combining the factors
The differing hedge ratios are determined by two diversification strategies:
The Equal Allocation Strategy (EAS) gives a 33.3% weight to the decision of each factor. The possible hedge ratios for each currency based on the direction the factors are pointing are:
The Majority Allocation Strategy (MAS) determines a hedge ratio based upon which direction the majority of the rules indicate currencies will go. If 2 point up, then the currency is 0% hedged; if 2 point down, it is 100% hedged. The MAS has bigger position swings and higher turnover in each currency, while the EAS’s adjustments are more gradual.
Chart 1 details the average excess return for each trading factor and the two combination strategies for each of our currency bases. It is interesting to note first that each of the naïve rules produces positive excess returns – quite a testimony to inefficiency in FX markets. At least one of the diversified combinations outperforms any individual factor – the way diversification is supposed to work. The MAS approach also generally produced superior returns.
Chart 2 shows the information ratios for each factor and their combinations. Here the information ratios of the EAS vs the MAS are a draw – they each produce more bang for the buck for the same number of currency bases. The Momentum factor is the most effective of the rules.
Charts 3 & 4 delineate the risk and return for the various base currency portfolios (3), and for the individual major currency pairs (4).
Both scattergrams divulge a common theme, whether for the entire portfolio or for the individual currency pair. Bigger bets taken by the MAS pay off with higher returns, but are bought by taking on more risk. The EAS produces competitive or more efficient and better risk-adjusted returns, depending upon the currency base. This can be seen by comparing the slope of a line moving from an EAS plot to its MAS pair with the solid equal risk/return line having a slope of 1. Moving out to the riskier MAS partner may produce more return, but it costs proportionally more in terms of risk. The slope is less than 1 and thus the risk-adjusted return is lower for several of the currency bases.
The results for individual currency pairs in Chart 4, indicate that for all pairs apart from the euro vs US dollar, the EAS combination produces higher information ratios.
Finally, the average hedge ratio and range of ratios is considered. Both combined strategies produce similar average hedge ratios across all currency bases. As might be expected, though, the standard deviation of the MAS hedge ratios is about twice those for the EAS, since it is a more aggressive strategy. Chart 5 details the average hedge ratio and the standard deviation for each currency base.
The range of hedge ratios across all currency bases seems similar, going from lows below 10% to highs in the 90% for the EAS. As expected, hedge ratios for the MAS strategy range from 0% to 100%.
The greater ranges shown for the more aggressive MAS strategy obviously produce greater portfolio turnover and consequent trading costs. Portfolio returns would be negatively impacted, and earlier observations about near equal information ratios, would be modified to conclude that portfolios using the EAS combination would have the efficiency edge and better risk adjusted returns.
It all depends on the investor’s goal.
If return is the objective, then more aggressive hedging strategies taking a wide range of varying hedge ratios, and quickly, would be called for. A winner take all approach might do nicely.
However, if lower risk is desirable, hedging strategies building and varying positions more gradually, from many information sources, seem to produce lower tracking error. Because of lower turnover, they’ll likely result in more efficient portfolios (better information ratios) and thus more attractive risk adjusted returns. For equivalent levels of risk they’ll produce better returns, and risk budgets might be better able to afford to allocate more money to such strategies.
Emmanuel Acar is principal at Bank of America in London. This article was written while he was at Citibank. Brian Strange is vice president and client portfolio manager in the currency management group of JP Morgan Fleming Asset Management in London. The opinions expressed in the article are those of the authors and not the authors employers’.
1Emmanuel Acar & Bapi Maitra, ‘Hedging Using Forward Rate Bias’, Risk, February 2001
2Roger Clarke & Mark Kritzman,
‘Currency Management Concepts & Practices’, an AIMR Publication, 1996