Michael McCoubrey examines the range of procedures available

It was in the mid seventies that fund managers first began to notice the impact of currency movements on the total returns of their international portfolios. Since that time there have been a number of examples that have reinforced the importance of adopting a conscious approach to currency management. Recently, most fund managers will remember the rapid depreciation of the yen which started in the summer of 1995 and the negative impact that this had on the $ returns reported on yen denominated investments. Today, in the search for yield, fund managers are looking to emerging markets. A casual glance at developments in Thailand will again remind investors that currency movements cannot be ignored. The real question is, can these risks be managed?".

What are the objectives of currency management? Simply, to be un-hedged when the base currency weakens, and fully hedged when it strengthens? There is a school of thought that believes that, unlike as-sets, there is no expected return in simply holding a currency. As the sophistication of international investment management techniques has evolved, this attitude has changed. Now, plan sponsors and trustees ex-pect foreign exchange management to add value and flexibility. Some managers argue that being fully hedged is the only pragmatic solution as currency adds volatility with no prospect of return, hedging is cheap, and second guessing assets is difficult enough without being forced to be a currency expert as well! Others will argue that any currency management is a development forced on investors by the shortening of the performance measurement cycle and, despite offering no long term value, has become a necessity in order to match returns achieved by peers. These debates will continue ad infinitum amongst academics, leaving most of us back in the real world looking for efficient strategies to minimise return volatility.

As with all aspects of effective fund management, the key for the manager becomes the investment benchmark. Currency benchmarks have evolved and whilst they can often be bound in with overall performance, they are crucial in dictating the style and risk appetite of the fund. Benchmarks will vary for a number of reasons, but the regulatory environment from which the original funds emanate, is often one of the most important factors. For instance most funds will not be allowed to be underweight in a currency without holding the underlying asset and many will restrict the use of derivative products (although this latter restriction is rapidly being relaxed). Once the currency benchmark is established, the appropriate foreign exchange product strategy can be determined.

It is standard procedure for in-vestors to continuously roll foreign exchange hedges until they are no longer required. However, this often implies an interest rate differential cost, and involves numerous transactions with net settlements. Occasionally there are liquidity problems when unwinding a hedge.

One of the simplest ways to reduce these risks is to choose a proxy (highly correlated) currency and thus facilitate a cheaper hedge, or access greater liquidity. The risks of this strategy have become all too apparent with the recent decoupling of the Singapore $ and Thai Baht. The overriding drawback of any cash market transaction is that it involves taking a view and committing the fund.

Recent years have seen a dramatic increase in the use of currency options by institutional investors. Their most common application is a purchase of a call to create an overweight position from neutral, or hedge an underweight position. For a known cost, the fund may enjoy the potential extra returns, whilst minimising risk. A few funds are buying options to establish underweight positions, but that is not yet 'market practice'.

Selling options, and generating a return from the added premium received is now becoming more common. This has long been practiced by fund managers holding equities or bonds, but is a relatively recent development in the management of foreign exchange exposure. In the past, the day-to-day administration of option positions was cumbersome and consequently put many fund managers off their use. Today this is much less of an issue as option risk management tools are cheap and readily available, and internal accounting and reporting systems are far more accommodative towards financial structures.

Those taking the use of options in foreign exchange benchmark management one evolutionary step further are using Basket options, taking advantage of correlations (high or low) between currency movements, which significantly reducing premium paid.

Further developments are now being led by those managers who are solely responsible for generating return from currency exposure. Last year, as volatility collapsed, many entered into 'range' structures. Effectively this is selling volatility to generate premium income. The Range Binary contract defines a trading range, and tenor. The fund will receive a payout as long as the market does not touch either extremity at any point during the life of the contract. If one of the levels is 'touched', then the up front payment is lost.

Banks who are providing these contracts are hedging their exposure using the vanilla options market, but that is entirely transparent to the fund, and therefore the contract is easily reported and accounted for. The fund only has a contingent risk for a known amount.

As mentioned earlier, the regulatory environment, or fund mandate may not extend tousing option or other derivative products in foreign exchange management. Such constraints are now being overcome by the use of Structured Notes. These investments have guaranteed minimum returns, shadowing the underlying investment, and can have options embedded to insure against currency depreciation (See box).

Again, the banks providing Structured Notes are using the derivatives market and vanilla options to create the product, but this is transparent to the purchaser of the note.

Another practice which is gaining in popularity is the use of volatility models in making currency decisions. The principle is that as volatility in a currency increases, the position, overweight or underweight, should be reduced. Conversely, as volatility reduces, the position size is increased. This results in more a more dynamic hedging strategy, although event risk following a period of low volatility may be an issue. i.e. When the fund is carrying the greatest exposure and volatility turns up sharply. Spikes in short term volatility are not always a concern to the institutional investor.

In April's edition of IPE, the article 'The edge is in the information' dealt with Value at Risk (VAR) - Associating probabilities with worst case scenarios, taking into account both vol-atilities and correlations within a portfolio. Admittedly this type of analysis is in its infancy, but does address the impact of derivatives, including options, on a portfolio. In future, VAR analysis will establish whether a portfolio is within acceptable loss limits. The foreign exchange manager then has to optimise the hedging strategy. 'Efficient Frontier' analysis is now being applied to this foreign exchange optimisation process, de-fining the mean variance efficient hedging combinations, and which best suit the risk preferences, benchmark constraints, and market view.

With all the developments discussed above, it is no longer a case of trying to fit a 'blunt' foreign exchange product into a dynamic investment strategy, but one of creating the foreign exchange hedge which best suits the portfolio, whilst allowing flexibility.

In the quest for that few extra basis points return, efficiency is a word which we will hear more and more.

Michael McCoubrey is global investor sales manager at Citibank in London."