Currency Management Expanding the Opportunity Set Cross Currency Pairs by MikeJenny


Currency Management Expanding the Opportunity Set Cross Currency Pairs

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									Expanding the Opportunity Set:
    Using the Currency Markets
       To Enhance Returns
        And Diversify Risk

    Jonathan P. Horgan, CFA, CAIA
                                        Executive Summary

        The currency market remains an untapped resource for many institutional investors,
primarily due to investor unfamiliarity, operational hurdles, and limited product offerings. Key
structural characteristics of the foreign exchange market include high liquidity, low transaction
costs, low correlations to traditional asset classes, mean reverting tendencies, and most importantly,
inefficiency. The source of this inefficiency is rooted in the competing interests of the underlying
participants. While some participants are profit oriented and thus price seekers, many participants
are non-profit oriented, and thus price takers.

        Recent studies indicate that it may be possible to exploit these inefficiencies through active
currency management. Furthermore, active currency management has a strong likelihood of
generating alpha. More specifically, active management (via active overlay or pure alpha programs)
using symmetrical mandates (i.e. 50% hedge ratio) and/or less restrictive investment guidelines
offers the most attractive risk/reward potential (as measured by information ratio) for investors.

       Despite observable market inefficiencies and attractive risk/return potential, active currency
management should not to be entered into lightly. Educational hurdles must be cleared before
embarking on this type of program, and operational procedures must be properly administered
before and after the program launches.

        The goal of this paper is twofold: to detail the size and structural characteristics of the
currency market, and to outline currency strategies currently available to international investors.
Particular emphasis will be paid to two empirical analyses performed on the merits of active
currency overlays, which also has implications for “stand-alone” currency alpha programs. Active
currency overlays are a proxy for currency alpha programs primarily because the same decision-
making process is used for both strategies, but the objectives and mechanics are slightly different.
Finally, this paper is designed as an internal discussion piece for IFS consultants to gauge whether
any of these strategies might be applicable to their client roster. If you have any questions or would
like to discuss this in greater detail, feel free to contact me.
Expanding the Opportunity Set: Using the Currency Markets to Enhance Returns and Diversify Risk


      The size and scope of the currency market has grown considerably since the abandonment of
the Bretton Woods fixed exchange rate system in the early 1970s. Concurrent with the move to a
free-floating exchange rate system, currency volatility has increased dramatically as various groups
of market participants (central banks, speculators, multinational corporations, and investors) exert
their unique objectives on the market. As the appetite for international investing (equity and fixed
income) has increased, more scrutiny has been directed at the inherent currency-related risk
associated with international investing.

Characteristics of the Foreign Exchange (F/X) Market

      Size of the Market and Types of Transactions
      The F/X market is the largest market in the world. According to the most recent (2004) Bank
for International Settlements (BIS) triennial survey, daily turnover is approximately $1.9 trillion. By
comparison, the daily turnover (2004) for all global equity markets was only $167 billion, while the
daily turnover for the NYSE was just $46 billion. Daily F/X transactions can be decomposed into 3
broad categories: swaps, spot trades, and forwards. As the table below illustrates, swaps account for
50% of all transactions and have experienced a 31% compound annual growth rate (CAGR) since
the early 1990’s. Spot transactions grew at a far less rapid pace (12%), but still accounted for 33%
of all transactions in 2004. Forwards accounted for only 11% of transactions, but experienced a
healthy 38% growth rate. The spot market tends to be dominated by speculators, while the swaps
and forwards markets tend to favor hedgers (multinationals and investors), although speculators
play a role there too.

       Transaction Type      1992      1995      1998       2001       2004      ( % of 2004)     CAGR
             Spot            $394      $494      $568       $387       $621         33%            12%
           Forwards           $58      $97       $128       $131       $208         11%            38%
            Swaps            $324      $546      $734       $656       $944         50%            31%
         Unclassified         $44       $53       $60        $26       $107          6%            25%
       Totals ($, billion)   $820     $1,190    $1,490     $1,200     $1,880

         Marketplace and Instruments
         Dealing in the foreign exchange market primarily takes place in a globally-linked, 24 hour
over-the-counter (OTC) market. Some transactions take place on futures exchanges, but their
relative size is dwarfed by the OTC market. Commercial and investment banks act as the principal
market makers/dealers; operating out of select locations in three specific time-zones (Asian,
European, and U.S.) and accounting for most of the daily turnover. London (31%) and New York
(19%) are the primary dealer locations, while Tokyo (8%), Singapore (5%), Hong Kong (4%) and
Sydney (3%) act as secondary dealer locations. The latter 4 locations collectively account for the
Asian time-zone, and overlap with London, which dominates the European time-zone. Trading
tends to be heaviest during the overlapping hours between the European and U.S. time-zones. As a
result, bid-ask spreads during the overlap tend to be narrow (2-5 basis points) and volatility tends to
be slightly higher. Alternatively, bid-ask spreads in the Asian time-zone tend to be wider (4-10),
and volatility is lower. Finally, global trading volume is generally concentrated in only a few
currency pairs, chiefly €/$ (28%), $/¥ (17%), and £/$ (14%). Other notable currency pairs include
AUD/$, $/CHF, $/CAD, and NZD/$. Please refer to the currency code table below for an
explanation of common currency abbreviations and their associated market terminology.

       INDEPENDENT FIDUCIARY SERVICES, INC.                                                              1
Expanding the Opportunity Set: Using the Currency Markets to Enhance Returns and Diversify Risk

                                                 Code       Currency (Market slang)
                                                  $         U.S. Dollar (“Greenbacks”)
                                                  €         European Euro (“Euro”)
                                                  ¥         Japanese Yen (“Yen”)
                                                  £         British Pound (“Cable, Sterling, Quid”)
                                                 AUD        Australian Dollar (“Aussie”)
                                                 CHF        Swiss Franc (“Swissie”)
                                                 CAD        Canadian Dollar (“Looney”)
                                                 NZD        New Zealand Dollar (“Kiwi”)

        Market Efficiency
        A continuous market characterized by daily turnover of approximately $1.9 trillion and low
transaction costs (narrow bid-ask spreads) is generally assumed to be “efficient.” Nevertheless,
closer examination of the foreign exchange market’s structural characteristics reveals just the
opposite. The primary reason for this lack of efficiency is rooted in the diverse, and oftentimes,
competing interests of the underlying market participants. More specifically, the motives of market
participants are not always based on profit (economic interest). Generally, the motives of market
participants are unique to the individual participant and irrespective of profit.

        An analysis of the timing of and motivation behind the foreign exchange money flows of
various market participants illustrates remarkable heterogeneity. For example, multinational
corporations enter and exit the foreign exchange market at random times, creating money flows
associated with international trade (export/import) and earnings repatriation. Similarly, central
banks enter and exit the foreign exchange market at random times, creating money flows by either
defending (buying) their home currency to avert a financial crisis (e.g. the Asian central banks
during the currency crisis of late 1990s), or by restraining (selling) their home currency to boost a
lagging export sector (e.g. the current activities of the People’s Bank of China and the Bank of
Japan). In addition, institutional investors and individuals (tourists) enter and exit the foreign
exchange market at random times, creating money flows through global investing and travel. Thus,
at any given time, the foreign exchange market is heavily populated with price takers, rather than
profit seekers. Accordingly, “the majority of market participants are net providers of structural
inefficiencies” (Sarah Reeves).

        Opportunity Set
        Empirical analysis indicates that the fair value of a currency (as defined by Purchasing
Power Parity1) generally holds for periods equal to or greater than five years, implying that currency
returns essentially wash out in the long-term. As a result, most institutional investors have never
considered the currency component of their international allocation as a potential source of
incremental return, believing that long-term returns converge/revert to zero. Consequently, most
dollar-based institutional investors have decided to leave their currency exposure unhedged.
Nevertheless, while the value of a currency tends to revert to its fair value (as defined by PPP) in
the long-term, its value in the short-term fluctuates between 2 and 3 standard deviations around that
fair value, providing multiple interim profit and loss opportunities. As Solnick and McLeavey note,
“regressions of monthly or quarterly exchange rate movements on inflation differentials yield low
explanatory power (R²)…Purchasing power parity is a poor explanation for short-term exchange
rate movements, and hence for exchange rate volatility, but it holds quite well over the long-run”
  Purchasing Power Parity (PPP) is an economic theory linking an expected future spot rate to the current spot rate via the relative inflation
differentials between 2 countries, whereby a country with a higher inflation rate has a depreciating currency. It implies that cross-border real returns
(inflation-adjusted) must be equal, as the exchange rate is simply a manifestation of the relative inflation differential.

         INDEPENDENT FIDUCIARY SERVICES, INC.                                                                                                   2
Expanding the Opportunity Set: Using the Currency Markets to Enhance Returns and Diversify Risk

(International Investments, 5th Edition). Not surprisingly, movements in currency markets exhibit
serial correlation and follow mean reverting patterns, implying latent profit opportunities via simple
trading rules (technical analysis). In the past, institutional investors have considered their currency
exposure in the context of their investment horizon, asking “Do currency returns wash out in the
long-term?” Based on the aforementioned structural characteristics of the foreign exchange market
(low transaction costs, high degree of liquidity, mean reverting tendencies, structural inefficiencies),
that question appears to be myopic. Institutional investors might reconsider their vantage point and
address currency exposure from a return and risk context, asking instead “Is there potential to
enhance returns and/or reduce risk in the short-term?”

       Data Analysis
       Historically, currencies have exhibited low correlations with traditional asset classes.
Correlation analysis using an equal-weighted basket of “major” currencies (£, ¥, DEM, AUD, CHF,
CAD) performed in Wilshire Compass reinforces this notion. As illustrated in Exhibit 1 and
Exhibit 2, the correlation (36-month rolling) between an equal-weighted basket of currency majors
and the Wilshire 5000 and the Lehman Brothers Aggregate Bond Index for the 20-year period
ending 9/30/2005 is very low, averaging 0.00 and 0.11 respectively.

                         Exhibits 1, 2 – Currency basket correlation analysis

        In addition to low correlations, currencies also exhibit lower relative risk. Risk analysis
(rolling 36-month) performed in Wilshire Compass using the same equal-weighted basket of major
currencies for the same 20-year period ending 9/30/2005 indicates an annualized standard deviation
of 5.62%, just 122 basis points higher than the annualized standard deviation of the LB Aggregate,
and significantly lower than the standard deviation of both the Wilshire 5000 (15.17%) and the
MSCI EAFE [Local Currency Net] (15.43%). Furthermore, the range of this rolling risk measure
(3.04%) is smaller than the range of the LB Aggregate (3.85%), implying less variability. Exhibit 3
graphically depicts the low relative risk of the basket of majors against 91-day Treasury Bills, the
Wilshire 5000, the MSCI EAFE [Local Currency Net], and the LB Aggregate.

        Currency risk resulting from international investment mandates tends to be greater for
international fixed income securities than it is for international equities, primarily because of the

       INDEPENDENT FIDUCIARY SERVICES, INC.                                                       3
Expanding the Opportunity Set: Using the Currency Markets to Enhance Returns and Diversify Risk

significant relationship that interest rates have on currencies and on bonds. As a result, many
international fixed income managers have developed the requisite skills to manage/mitigate this
embedded risk, while many international equity managers have traditionally ignored this risk. Not
surprisingly, currency overlay programs exhibit a skew toward international equity mandates, rather
international fixed income ones.

                           Exhibit 3 – Currency basket relative risk analysis

       Given their low correlations and their low relative risk, currencies would appear to be an
ideal choice for inclusion in any portfolio geared towards maximum efficiency. Nevertheless,
choosing an appropriate currency strategy requires careful consideration of many investor-specific
variables, including: liquidity needs, return objectives, risk tolerance, and existing asset allocation.

Currency Strategies

      Hedge Ratio
      Before discussing the types of currency strategies currently available, it is important to define
and describe a key term which has major implications for the implementation of and historical
success of each strategy. In simple terms, a hedge ratio represents the percentage of a portfolio (or
benchmark) which has been hedged (protected) against an adverse outcome. More importantly, the
hedge ratio represents the currency “risk-neutral” point for an investor over a long-term investment
horizon. For example, an investor may determine that it is appropriate (given his risk/return profile)
to hedge 50% of the underlying currency exposure in order to arrive at a “risk neutral” point. Lastly,
in order to ensure adequate performance measurement, the hedge ratio normally serves as a proxy
value for the benchmark.

       Hedge ratios should be customized to an investor’s unique return/risk profile and asset-
liability structure, rather than standardized at an arbitrary or universal figure. Accordingly, as

       INDEPENDENT FIDUCIARY SERVICES, INC.                                                       4
Expanding the Opportunity Set: Using the Currency Markets to Enhance Returns and Diversify Risk

return/risk profiles and asset-liability structures dynamically adjust/change over time, so too should
the hedge ratio. In addition, hedge ratios generally range from 0 to 1, although they can occasionally
exceed these bounds, depending on whether the overlay mandate allows for leverage. A hedge ratio
of 0 (0% hedged) implies that a portfolio remains fully exposed to an adverse currency movement,
while a hedge ratio of 1 implies that a portfolio has no exposure (100% hedged) to an adverse
currency movement. In terms of currency overlays, these two types of hedge ratios (0% hedged and
100% hedged) are normally associated with polar or asymmetrical mandates, due to their extreme
values. A hedge ratio of .5 (50% hedged) implies that a portfolio has 50% exposure to an adverse
currency movement, and is usually associated with a symmetrical mandate.

      In a currency overlay program, the underlying currency exposure and benchmark (hedged,
fully hedged, or partially hedged) of a portfolio transfer from the investment manager (underlay
manager) to the overlay manager, who uses the hedge ratio as the primary tool to manage the
underlying currency risk. In a passive currency overlay program, the objective is not predicated on
generating value-added incremental returns. Rather, the objective is predicated on risk
minimization. The overlay manager accomplishes this task by periodically adjusting the hedge ratio
in order to align portfolio currency exposure with benchmark currency exposure. Alternatively, in
an active currency overlay program, the objective is to earn an incremental return. Accordingly, the
overlay manager tactically adjusts the hedge ratio in order to vary portfolio currency exposure with
benchmark currency exposure. If active overlay opportunities do not exist, the manager simply
reverts to the weights of the benchmark. Overlay strategies primarily use forwards to adjust the
hedge ratio, although other types of derivatives (futures, swaps, and options) are also used, albeit
less frequently. The use of forwards allows investors to fund overlay programs at a low cost, but
does increase credit/counterparty risk. Cash equitization pools are typically used as the primary
investment vehicle for residual cash and cash associated with the settlement of forwards. These
pools effectively minimize tracking error by investing cash in international equity index futures,
thereby creating exposure to the desired asset class.

      Implications of Symmetrical and Asymmetrical Mandates for Currency Overlays
      In the currency overlay world, an investment mandate can loosely be described as the
acceptable hedging range and the assigned benchmark. Mandates fall into two broad categories:
symmetrical mandates and asymmetrical mandates. A symmetrical mandate permits the overlay
manager to deviate from the benchmark in either direction (net long or net short), provided the
deviation band is symmetrical (e.g. +/- 25%). An example of a symmetrical mandate would be a
50% hedged benchmark with a 0% to 100% hedging range, implying that the overlay manager can
adjust the hedge ratio +/- 50%. Conversely, an asymmetrical mandate permits the overlay manager
to deviate from the benchmark in only one direction. In addition, the deviation is effectively bound
by the upper or lower limits of the benchmark (hedged or unhedged). An example of an
asymmetrical mandate would be an unhedged (0%) benchmark with a 0% to 100% hedging range,
implying that the overlay manager can only adjust the hedge ratio +100%.

      Empirical analysis of asymmetrical mandates indicates that they are sub-optimal, primarily
because of their directional bias. In the case of a portfolio with a fully hedged (100%) benchmark,
currency exposure has already been minimized via the transferred benchmark. As a result, the
overlay manager can only adjust the hedge ratio in one direction (down, or < 100%), because the
benchmark places a cap/ceiling on the overlay. Thus, even if the overlay manager is extremely
bullish on the domestic/base currency, he cannot hedge more than 100% (i.e. go net long) because
of the limits placed on him by the benchmark, unless leverage is allowed. Moreover, the overlay

       INDEPENDENT FIDUCIARY SERVICES, INC.                                                       5
Expanding the Opportunity Set: Using the Currency Markets to Enhance Returns and Diversify Risk

manager will only adjust the hedge ratio if he feels that the home currency is overvalued relative to
the foreign currency. As a result, he can only execute one specific trade — selling the home
currency and buying the foreign currency (i.e. reduce the hedge), which results in a directional bias.

      Alternatively, in the case of a portfolio with an unhedged (0%) benchmark, currency exposure
has been ignored. The overlay manager can only adjust the hedge ratio in one direction (up, or >
0%), as the benchmark places a floor on the overlay. Thus, even if the overlay manager is bearish
on the home currency, he cannot hedge less than 0% (i.e. go net short) because of the limits placed
on him by the benchmark, unless leverage is allowed. Furthermore, the overlay manager will only
adjust the hedge ratio if he feels the home currency is undervalued relative to the foreign currency.
As a result, the manager can only execute one specific trade — buying the home currency and
selling the foreign currency (i.e. increase the hedge), which results in a directional bias.
Consequently, “asymmetrical mandates, such as an unhedged benchmark with a 0 percent to 100
percent hedging range, do not allow the manager as much opportunity to add value in all currency
environments.” (Baldridge, Meath, Myers)

      Symmetrical mandates (50% hedge ratio) improve upon the inherent flaw of
polar/asymmetrical mandates by expanding the opportunity set available to the manager. With a
symmetrical mandate, a manager can adjust the hedge ratio in either direction — increasing the
hedge ratio when the domestic/base currency is undervalued, or decreasing the hedge ratio when the
domestic/base currency is overvalued. Thus, symmetrical mandates allow the overlay manager to go
net long or net short around the benchmark. As a result, “the manager is allowed the flexibility to
win in all currency environments, thus increasing the potential for achieving more consistent
alpha and lower tracking error” (Baldridge, Meath, Myers).

      Role and Selection of the Benchmark in the Context of Currency Overlay
      The role of a benchmark in a currency overlay program is analogous to its role in traditional
investment management, with the added twist of its impact on the symmetry (or lack thereof) of the
investment mandate. Accordingly, the benchmark acts as both a bogey to measure and decompose
performance, and as a critical determinant in the risk management process. Benchmark selection
essentially drives risk exposure. More specifically, “when selecting a multi-currency benchmark,
the investor (implicitly or explicitly) makes both a decision on a set of underlying assets and a
decision on the desired level of embedded currency exposure” (John C. Stannard). However, as
mentioned earlier, benchmarks with extreme values (0% hedged or 100% hedged) implicitly set
limits on the hedge ratio, thereby curtailing the discretion the overlay manager has to seek to add
value in all currency environments.

      The selection of a benchmark involves two distinct choices. The first choice determines the
components of the hedging program, while the second choice determines the symmetry of the
investment mandate. In the first choice, the investor must choose between the implied currency
exposure of a particular benchmark (e.g. country weights of MSCI EFAE or MSCI ACWI, ex U.S.),
or the actual currency exposure of the underlying assets in their portfolio. Investors…“who view
overlay as pure hedging strategies prefer assigning the underlying currency exposures of
international equity managers, whereas investors who worry about ease of implementation prefer
the…(benchmark) exposures” (JPMorgan Fleming). In the second choice, the investor must choose
an appropriate benchmark — partially hedged (30%, 50%, 80%, etc.), unhedged (0%), or fully
hedged (100%); mindful of the fact that “an appropriate currency overlay benchmark…must reflect
the nature of the assignment” (John C. Stannard).

       INDEPENDENT FIDUCIARY SERVICES, INC.                                                       6
Expanding the Opportunity Set: Using the Currency Markets to Enhance Returns and Diversify Risk

      Strategy Type 1: Passive Overlay
      In a passive overlay program, the hedge ratio is defined by the country weights and value
(unhedged, partially hedged, fully hedged) of the referenced benchmark. The net result of a passive
overlay strategy is minimization of currency risk, relative to the benchmark. In this type of
strategy, currency risk is minimized (partially or fully) at the benchmark level. An investor who
uses a passive overlay defined against an unhedged benchmark neutralizes the active currency risk
associated with a country bet. So, the overlay manager who inherits a portfolio with an overweight
(+30%) in Japan would reduce the excess ¥ exposure, but not completely eliminate it. Alternatively,
an investor who uses a passive overlay defined against a fully hedged benchmark completely
neutralizes all currency risk. A passive overlay strategy is appropriate for an investor who is
comfortable with defining their risk level in the context of the benchmark. It is worth noting that
well written and comprehensive investment guidelines addressing country weights (e.g. +/- 5%
bands, or country neutral) and the benchmark (MSCI EAFE - hedged) represent de facto passive
overlay as defining those two variables effectively defines currency risk exposure. Most current
investment manager guidelines written by IFS explicitly set limits on country weights, but grant the
manager discretion to hedge currency exposure. In addition, most managers are benchmarked
against unhedged benchmarks. As a result, most of these mandates are de facto asymmetric passive

      Strategy Type 2: Passive Currency Management (Passive Hedging)
      In a passive hedging strategy, the hedge ratio is fixed and the portfolio is continuously
adjusted to ensure that the fixed hedge ratio is maintained. The net result of a passive hedging
strategy is minimization of currency risk, where risk is specific to the investor. In this type of
strategy, currency risk is minimized (partially or fully) at the investor level. Passive hedging is
primarily used by non-dollar investors (Swiss, Australian, or Japanese pension funds) with large (≥
50%) and broad (equity and fixed income) international exposure. Studies indicate that passive
hedging is of limited value as costs (opportunity, administrative, management, funding) tend to
outweigh benefits. Given that all IFS clients are $-based investors, passive hedging appears to be an
inappropriate option.

      Strategy Type 3: Active Overlay
      In an active overlay strategy, the hedge ratio is variable. More specifically, an active overlay
manager strategically adjusts the hedge ratio (around the benchmark) in response to opportunistic
market conditions in order to reduce risk and/or enhance returns. The net result of an active overlay
strategy is minimization and disaggregation of currency risk, where risk is defined at the total
fund level, the sector (country) level, and the manager level. Risk disaggregation at the total
fund level implies greater flexibility in risk budgeting and asset allocation; the byproduct of low
correlations. “The major benefit of currency overlay programs in an overall portfolio context is that
they can (a) lower the volatility of international equity investments; (b) lower the frequency of large
negative outcomes in portfolios; and (c) produce an alpha stream that is uncorrelated with the
returns from standard bond and equity investments.”(JPMorgan Fleming). Risk disaggregation at
the sector level involves bifurcating the risk of an international investment (currency risk vs. non-
currency risk). Thus, while investing in the FTSE may look attractive, investing in $/£ may look
unattractive. Risk disaggregation at the manager level implies that the skill set of a good stock
picker or bond analyst is completely unrelated and independent to the skill set of a currency trader.
Therefore, an active overlay strategy may be appropriate for an investor who is concerned with
year-to-year returns variance stemming from the embedded currency risk of an international

       INDEPENDENT FIDUCIARY SERVICES, INC.                                                       7
Expanding the Opportunity Set: Using the Currency Markets to Enhance Returns and Diversify Risk

allocation and willing to delegate authority to a currency specialist in order to manage this risk.
Active overlay strategies may be appropriate for those IFS clients with large (≥ 15%) international
exposure who wish to minimize risk and/or seek to add incremental returns from active currency

       Strategy Type 4: Active Currency Management (Currency as Asset Class/Pure Alpha)
       In active currency management (pure alpha), currencies are treated as a separate asset class.
Positions/benchmarks do not transfer from the underlying non-U.S. assets to the overlay manager.
As a result, the concept of a hedge ratio is irrelevant. In a pure alpha strategy, the currency
manager trades currencies (usually spot transactions and forwards) in a separate account
(established via an F/X trading line) on behalf of the client, effectively disregarding the underlying
currency exposure of the client’s international allocation (if any). The objective of this strategy is to
maximize return. Due to its risk additive nature and tendency to use leverage, this type of strategy
requires strict investment guidelines and thorough asset allocation modeling. Accordingly, it is not
appropriate for the novice investor. Nevertheless, currency alpha programs offer low correlations
with traditional asset classes and latent profit opportunities via persistent structural market
inefficiencies. In addition, currency alpha programs are closely related to active overlays — “To
profitably buy and sell currencies entails applying the same management and decision processes
that are employed to hedge currency exposures actively.” (Alfred G. Bissett). Thus, if a client
understands the logic behind an active overlay strategy, he/she may be willing to explore a pure
alpha program instead of/in addition to an overlay program. “Oftentimes a Plan Sponsor will choose
to undertake both activities. By managing the preexisting currency risk associated with their
international investments (active overlay), the risk budget saved can then be efficiently redeployed
into higher yielding strategies such as currency as an asset class.” (Pareto Partners) Unfortunately,
this strategy is relatively novel and performance records are scarce.

Empirical Analyses of Active Currency Overlays

      “Capturing Alpha through Active Currency Overlay”: Baldridge, Meath, Myers (5/ 2000)
      The seminal work outlining the success of active overlay strategies was published in May
2000 by three consultants with the Frank Russell Company. The results of their analysis are
summarized in this paper. The author strongly encourages all IFS personnel interested in either
active overlay strategies or currency alpha programs to read the referenced document.

      The authors examined a data set comprised of 241 (166 active, 75 terminated) active overlay
(equity only) accounts from 18 different firms representing $85 billion in assets under management.
The period covered was December 31, 1988 to June 30, 1999. Accounts were then grouped into
equally weighted composites defined along two dimensions: base currency ($-based, other) and
hedge ratio (0%, 50%, and 100%). Four analytical statistics (monthly) were used to draw
conclusions from the data set, including: success ratio (% of time results were positive), average
annualized excess return (active overlay return less benchmark return, gross of fees), average
tracking error, and annualized information ratio.

      The results of this study are consistent with an earlier (1998) study conducted by Brian
Strange highlighting the relative value of symmetrical mandates over asymmetrical ones. Results
for the $-based composites are delineated in the table below. While the 0% hedge ratio composite

       INDEPENDENT FIDUCIARY SERVICES, INC.                                                       8
Expanding the Opportunity Set: Using the Currency Markets to Enhance Returns and Diversify Risk

produced the highest excess return (+2.19%), it also produced the highest overall tracking error
(+2.76%). Conversely, the 50% hedge ratio (symmetrical) composite produced the lowest overall
tracking error (+1.80%) coupled with an impressive (+1.17%) excess return. The 100% hedge ratio
composite produced an excess return of 0.52%, and a tracking error of 2.25%.
      Average Excess Return               Average Tracking Error            Annualized Information Ratios
  50% hedge ratio = 1.17%               50% hedge ratio = 1.80%             50% hedge ratio = 0.64
  100% hedge ratio = 0.52%              100% hedge ratio = 2.25%            100% hedge ratio = 0.10
  0% hedge ratio = 2.19%                0% hedge ratio = 2.76%              0% hedge ratio = 1.00
  Total = 1.48%                         Total = 2.63%                       Total = 0.63

     The high excess return exhibited by the 0% hedge ratio, and conversely the low excess return
exhibited by the 100% hedge ratio, are highly dependent on the sample period (time period bias)
and opportunity set (directional bias). “Unhedged portfolios benefited most from a strengthening
US dollar during this period because any hedging resulted in favorable excess returns against an
unhedged benchmark. The hedged accounts faced an uphill battle over recent time periods
because their primary “value added” position did not differ from the benchmark.” (Baldridge,
Meath, Myers)

      A boxplot depiction of excess returns of symmetrical mandates for the calendar year periods
1992 through 1998 reveal median returns ≥ 0% in six out of the seven periods, and 25th percentile
returns ≥ 0% in four out of the seven periods. “Given an expected median excess returns of zero for
most investment strategies, 75% of managers achieving positive results is impressive”(pp. 9-10).
Rolling 3-year and 5-year excess returns analysis is equally impressive, revealing “consistently
positive excess returns for the 50 percent hedged benchmark…(which) illustrates the benefits
associated with symmetric positioning opportunities in different currency environments”(page 11).
Furthermore, rolling 3-year and 5-year tracking error analysis for the 50% hedged/symmetrical
mandate reveals a relatively narrow range between 2% and 3%, which should be intuitive, “because
symmetrical mandates allow the manager greater investment flexibility regardless of the currency
environments”(page 11). Moreover, the rolling 3-year and 5-year tracking errors of the symmetrical
mandate, when compared to similar data of traditional asset classes, “falls between the tracking
errors of US fixed income and US equity managers and is well below the non-US equity managers”
(page 12). Thus, “the combination of…consistent excess returns and low tracking errors present an
intriguing case for considering active currency overlay strategies to enhance an investor’s global
portfolio” (page 13).

      “Currency Overlay Managers Show Consistency”: Brian Strange (6/1998)
      An earlier but less exhaustive analysis attempted to answer the relatively simple question, “Do
currency managers add value?” The author examined a data set of 152 currency overlay
assignments (symmetrical and asymmetrical), representing 11 different firms. Excess returns
relative to an assigned benchmark were the primary statistic used to determine value added
performance. The results of this analysis are consistent with the results of the Baldridge, Meath, and
Myers analysis.

     Performance analysis for all overlays reveals an average annual alpha of 1.9%. In addition,
80% of accounts outperformed their benchmark, producing an average annual alpha of 2.4%. The
standard deviation of the alpha was 3.5%, resulting in an information ratio of 0.54. Correlation

       INDEPENDENT FIDUCIARY SERVICES, INC.                                                         9
Expanding the Opportunity Set: Using the Currency Markets to Enhance Returns and Diversify Risk

analysis on the excess returns of active overlay managers revealed an average correlation of 0.20,
implying that the alpha source is skill-based, not market-based. Furthermore, risk analysis revealed
a standard deviation that was lower than the underlying performance benchmarks, implying value-
added risk reduction. More importantly, analysis showed that symmetrical mandates had more
consistent alphas (lower tracking error) than asymmetrical ones. Finally, the author shows that
overlay managers who are afforded more latitude (cross-hedging, proxy hedging) also produced
more consistent alphas.

Implementation Issues

     Conceptual and operational hurdles make currency overlays less attractive than traditional
investments. As Baldridge, Meath, and Myers note, “while the excess return potential is attractive,
implementation and operational considerations may be formidable to some investors and may even
diminish potential investment benefits. Currency overlay strategies have complexities that investors
must understand and be prepared to tackle. The concept of overlaying another asset class, the use of
derivatives, and the unique payoffs of these strategies require an educational commitment by the
investor to implementation and continuous monitoring thereafter.” A few of the primary issues an
investor must consider when implementing a currency overlay strategy include:

    1. Benchmark selection
                 i. Symmetry (50% hedge ratio) vs. asymmetry (0% or 100%)
                ii. Exposure to hedge (actual or benchmark)

    2. Return objectives
                  i. Usually stated as excess return (alpha), gross of fess
                 ii. Usually 100 to 200 basis points over benchmark

    3. Risk Parameters
                  i. Usually stated as standard deviation of alpha (tracking error)
                 ii. Usually 1.5 – 2x alpha target

    4. Investment Guidelines (restrictive or unrestrictive)
                  i. Leverage
                         1. Hedging more/less than underlying exposure
                 ii. Strategy
                         1. Cross hedging - (Opportunistically swapping exposure from one
                            currency for another currency where the latter offers greater return
                         2. Proxy hedging – (Using proxy currency where liquidity is
                iii. Types of Contracts
                         1. Spot, forwards, futures, options, swaps
                iv. Types of Currencies
                         1. Developed and/or developing world

    5. Funding
                     i. Management of day-to-day cash flows

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Expanding the Opportunity Set: Using the Currency Markets to Enhance Returns and Diversify Risk

                            1. Daily mark to market until settlement/maturity
                     ii. Allocation of any profits
                            1. Cash equitization pool
                    iii. Funding of any shortfalls
                            1. Cash reserve

    6. Operations
                      i. Communication
                            1. Establish a link between underlying manager, custody bank, and
                               overlay manager
                                   a. Size and exposure of underlying to overlay
                     ii. Performance
                            1. Stand alone or part of international
                    iii. Custody account (separate) must be established
                    iv. Credit Lines must be established to effectuate forwards
                            1. Counterparty risk must be minimized

    7. Manager selection
                  i. Performance record
                 ii. Assets under management
                iii. Opaqueness of investment process
                iv. Approach
                         1. Fundamental/Macroeconomic
                         2. Technical
                         3. Hybrid


      Currency management (active overlay, pure alpha) is a relatively new phenomenon in the
capital markets. Many investors have yet to embrace this market despite appealing characteristics,
including: low correlations with traditional asset classes, low relative risk to traditional asset
classes, latent profit opportunities via persistent structural inefficiencies, and low transaction
costs/high liquidity. Moreover, empirical analyses on the merits of active currency management
reveal value-added benefits in terms of risk and return. Educational and operational hurdles appear
to make venturing into this market highly cost-intensive. Consultation with overlay and pure alpha
managers may allay these fears. As a result, the author intends to meet with multiple firms which
offer active currency management services over the next several months. If you wish to explore this
topic in greater detail and wish to participate in these meetings, please let me know.

       INDEPENDENT FIDUCIARY SERVICES, INC.                                                       11
Expanding the Opportunity Set: Using the Currency Markets to Enhance Returns and Diversify Risk


Baldridge, Janine and Meath, Brian, and Myers, Heather. 2000. “Capturing Alpha through Active
Currency Overlay.” Russell Research Commentary (May)

Strange, Brian. 1998. “Currency Overlay Managers Show Consistency: In the Long Run, Count on
Them for Adding Value.” Pensions and Investments Online (June 15)

Stannard, John C. 1998. “Benchmarks and Performance Attribution Subcommittee Report.” CFA
Institute (August)

Duncombe, Paul. “Currency Investment Policy is Not Bliss.” State Street Global Advisors - Paper.

Feld, Karen Parker and Rich, Donald and Steward, Christopher. 2005. “Affordable Alpha: Active
Currency Management in International Equity Portfolios.” Wellington Management Company -
White Paper (August)

Smith, Ralph. 2003. “Currency Hedging for European Investors” State Street Global Advisors -
Essays and Presentation (September)

Jones, Philip L. 2001. “Currency Overlay: The Dynamic View” Alternative Investment
Management Association (June)

Trammell, Susan. 2003. “Risky Exposure: Currency Exchange in Global Investing.” CFA Magazine

Opiela, Nancy. 2005. “Pension Plans on a Quest for Alpha.” CFA Magazine (March-April)

State Street Global Advisors. 2004. “A Case for: Active Currency Management, An Overlooked
Exposure Provides Attractive Opportunity.” White Paper (December)

Chrispin, Gregory. 2004. “Managing Currency Risk – The Canadian Perspective.” State Street
Global Advisors – Essays and Presentations (March), “Currency Overlay Program”

JPMorgan Fleming Asset Management, “Currency Management Q&A.” Currency Insights Paper

JPMorgan Fleming Asset Management, “Currency Overlay: A Potential Source of Alpha and a
Proven Source of Risk Management.” Currency Insights Paper

JPMorgan Fleming Asset Management, “A 10-Step Implementation Plan for Currency Overlay.”
Currency Insights Paper

O’Neill, Jim. 2004. “The Foreign Exchange Market.” Goldman Sachs Economics Research.

       INDEPENDENT FIDUCIARY SERVICES, INC.                                                       12
Expanding the Opportunity Set: Using the Currency Markets to Enhance Returns and Diversify Risk

Bank for International Settlements. 2005. “Triennial Central Bank Survey: Foreign Exchange and
Derivatives Market Activity in 2004.” (March)

Bridgewater Associates. “Currency Observations: Developing an Effective Currency Overlay
Program – The Nuts and Bolts.”

Reeves, Sarah. “Currency Management Comes of Age.” 2005. (May)

Bisset, Alfred G. “Currency Alpha Programs Can Increase Investment Returns.” 2005. (May)

Solnick, Bruno and McLeavey, Dennis. 2004. “International Investments” 5th Edition - AIMR.

Pareto Partners, “Customizing Currency Programs to Meet Plan Sponsors’ Investment Objectives.”
2005 (September)

       INDEPENDENT FIDUCIARY SERVICES, INC.                                                       13

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