Active Currency Hedging
Overlay Asset Management believes that currency exposure can be used to enhance returns, via an active currency overlay. Not all currency market transactions are profit maximizing – they are often secondary reflections of transactions in other markets – and this creates inefficiencies in currency markets which can be exploited by managers explicitly focused on doing so. This characteristic, combined with the high liquidity and low transaction costs of many currencies, makes currency markets an attractive candidate for active management.
The objective of an active currency hedge is to replace random currency risk with managed currency risk. Whilst active currency hedging allows for return enhancement, its main focus is risk management; but “smart” risk management, as opposed to a consistently applied passive hedge ratio. It is designed to manage currency risk exposure with the objective of protecting the investor from depreciating foreign currencies but allowing the investor to benefit from exposure to appreciating foreign currencies.
The investor chooses a benchmark hedge ratio, 50% for example, and the currency manager varies the actual hedge ratio for each foreign currency exposure according to the manager’s outlook for that currency. Where the currency manager forecasts that a foreign currency will depreciate, the manager should increase the hedge ratio above 50%, to protect the investor; and where the currency manager forecasts a foreign currency to appreciate, the manager should decrease the hedge ratio below 50% to allow the investor to more fully participate in that appreciation.
Generally, the minimum hedge ratio of an active hedging programme is not less than 0% for any currency, so at worst, the underlying currency exposure can remain completely unhedged, but the currency manager cannot increase the investor's exposure to a currency beyond the exposure that already exists in the underlying portfolio. And generally, the maximum hedge ratio of an active hedging programme is no more than 100%, so the most a manager can do is completely hedge the underlying portfolio’s exposure to a given currency, but it cannot hedge more exposure that actually exists in the underlying portfolio, i.e. it cannot create a “short position” on any foreign currency.
The main advantages of active currency hedging programmes are:
- Exposure to currency risks in a portfolio can be controlled and currency investment decisions can be unbundled from decisions pertaining to the underlying asset classes.
- Specialist manager can seek returns and/or manage risk in each asset class. For example, a currency manager can be retained to manage currency risk, whilst an equity manager focuses on equity investment decisions.
- Administrative functions (like the monitoring of overall currency exposures, hedging policy and performance reporting) can be centralised at a higher level within a fund. This is particularly valuable for investors with several fund managers, portfolios or funds into which they invest.
For more information on Overlay Asset Management’s active currency hedging solutions, please contact us.