Curreny Overlay Strategy
Posted on: June 22, 2009 - Email Article - Printable Version
In today’s investment climate, asset managers have come to the realization that now, more than ever, geographic diversification is key. Gaining access and direct exposure to foreign equity and debt securities, however, comes with a complicating factor that requires analysis and attention when compared to domestic investment decisions – that factor is FX market risk.
For any asset manager, the decision to invest in foreign currency denominated securities must be made after weighing the relative risk and return of both the securities themselves, as well as the expected currency performance versus the asset manager’s reporting or home currency. A currency overlay strategy provides a means by which to separate and mitigate the currency risk from the investment risk decision-making process. Essentially, the aim of the strategy, as employed, is to allow the asset manager to gain access to foreign currency denominated security exposure without accepting the risk of a depreciating USD (or other foreign currency). In so doing, the overall performance of the manager is solely dependent upon the relative return of the security in question and is independent of the volatility of the underlying currency exposure (their FX position being partially if not fully hedged). Essentially, a currency hedge allows one to freely invest abroad based on the merits of the security alone, without having to take into account the macro factors that can impact both short and long-term currency valuations.
If an asset manager doesn’t have a definitive perspective of the currency pair’s direction, or is at all unsure of the timing or scale of forecasted movements, a currency overlay strategy can be executed to deliver a currency neutral performance of the foreign investment. In its simplest form, an overlay strategy can take the form of a perpetual or term-based forward hedge. It is either strategically rolled, to best manage the cost or opportunity of carry, or simply rolled at periodic intervals, so as to realize the mark-to-market value of the currency offset. Though a forward-based currency hedge will unquestionably deliver the most efficient price and execution, it fails to allow for any upside participation in a more favorable market movement.
With the execution of an option-based strategy as opposed to a forward-based sale, the investment manager can effectively cap the downside risk associated with an unfavorable currency movement while also affording oneself the ability to fully participate in favorable market movements, after having taken into account the premium expense of a vanilla option.
Though market volatility levels remain elevated, enhancing the chances of a windfall gain from an outsized favorable movement, so too do option prices; however, the option prices are a direct result of that elevated volatility. In the present market environment, many asset managers are looking to structured option products that offer reduced levels of upside market participation in exchange for a reduced or negated option premium. By capping or limiting the potential upside risk of a strategy with an opposing sold vanilla option or barrier trigger, one can reduce or eliminate the associated premium expense entirely while still maintaining some upside participation.
Though overlay strategies are typically employed alongside a long or short position in a foreign denominated security, many asset managers also employ currency hedges in anticipation of taking on a foreign position at some point in the future. Given the relative underperformance of the pound sterling in recent months, as an example, one might elect to go long GBP with a forward or option-based hedge to lock in the relatively attractive currency levels while waiting to step into an equity position after a short-term retracement in equities. Though one could argue that the current market environment would favor a lower pound, should equity valuations, particularly in the UK, tail off once again on general market risk aversion, it is conceivable to believe that a short-term corrective pullback in equity market appetite wouldn’t materially impact currency valuations in the medium-term. If this is consistent with the asset manager’s view, it could very well be prudent to go long the currency at today’s level, hedging against the risk that a risk-sensitive pound sterling eats into the profitability of a future underlying security position.
Although an equity purchase in an emerging market wouldn’t likely be met with a conflicting view on the domestic currency in the present market environment where currencies and equities remain highly correlated, the validity of an overlay strategy becomes apparent when evaluating the relative merits of a US-based equity purchase by a Canadian asset manager. Given the USD’s strongly inverse correlation with equities in today’s risk sensitive climate, today’s asset manager must take care to evaluate the relative risk and reward scenarios of such a foreign exposure. After all, successful investment management is as much about risk mitigation as it is risk acceptance.
- Mark Frey
Disclosure: None.
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