By Marianne Winkelman, VP, Director of Global Bond, EM & FX Trading
The foreign exchange (FX) market is the largest, most liquid financial market in the world, with daily turnover of $5.1 trillion.i For investors allocating outside of their home currency, there are infinite complexities, opportunities and risks to consider—starting with the decision to either take active currency exposure or hedge.
At Loomis Sayles, most products are involved in the FX market, whether that means taking active views and using currency to generate alpha or hedging to neutralize some or all currency exposure. Our centralized trading structure includes a team of experienced FX traders who effectively execute all FX for the firm using proprietary technology, third-party platforms and automated processes. The FX desk trades the highest notional volume at the firm.
Like all areas of trading at Loomis Sayles, our FX traders are asked to make meaningful contributions to alpha generation across all portfolios. Our approach to FX is:
Hedging is an option for investors who want to own a security issued in a foreign currency but do not want the currency exposure. Investors may hedge because they do not take active currency positions or because they view a security positively but view the currency negatively. FX hedges neutralize currency risk, meaning investors will not participate in either depreciation or appreciation of a currency, which can lower portfolio volatility.
FX forwards are the most common way to hedge, but there are other methods including the use of FX options or cross-currency basis swaps. Each method has different risks, requirements and costs. The investor’s objectives, concerns and risk tolerance should be used to determine the most appropriate method. Factors including the portfolio’s underlying assets, base currency, foreign currency exposures, investment horizon and guidelines are all considerations.
An FX forward is an agreement to exchange a predetermined amount of one currency for another currency at an agreed-upon rate and at an agreed-upon value date (or settlement date) sometime in the future.
In practice, it is common to “roll” forwards to maintain a hedge position and avoid exchanging large amounts of cash on the value date. Later, we will walk through an example of hedge trades and discuss how rolling is done, including related cash requirements.
It is standard market practice to hedge in one- to three-month tenors. Under normal market conditions, we hedge to three-month (quarterly) International Monetary Market (IMM) dates. The IMM is a division of the Chicago Mercantile Exchange (CME). However, our FX traders have hedged from one month to ten years in order to meet the specific needs of a client or investment team, or because of technical factors in the market.
We regularly monitor hedge costs and forward curves to determine the most efficient tenor for a given currency pair.
Today’s forward prices combine covered interest rate parity and the cross-currency basis. But in the mid-1990s, we calculated forward rates using covered interest rate parity, Libor curves, a day-count calendar and our HP12C financial calculators. Two things have changed since then: Bloomberg automated the FX forward pricing calculation, and the global financial crisis increased the cross-currency basis. Here’s a look at each factor:
1) Covered interest rate parity refers to a theoretical condition where the relationship between the interest rates, spot rates and forward rates of two countries are in equilibrium. It is used to calculate the forward exchange rate:
2) The cross-currency basis is a rate that reflects the supply/demand dynamics of borrowing or lending one currency against another, and counterparty risk. Prior to the global financial crisis, the cross-currency basis was generally negligible. But the crisis generated massive US dollar demand and FX counterparty risk, which made the cross-currency basis significant in many cases. Post crisis, it is now incorporated into the price of FX forwards.
The cost or gain of a hedge is the price of the FX forward rate relative to the FX spot rate. This hedge cost/gain is set when the contract is initiated, and it is unavoidable. Generally, the higher the foreign interest rate versus the domestic interest rate, the higher the hedge cost.
Hedge costs/gains change with global interest rate differentials and the cross-currency basis, so there can be sizeable moves over time. For example, over the past 10 years for a US-based investor hedging euros back to US dollars, the hedge return has ranged from a gain of 2% to a cost of 2%. For a Japan-based investor hedging US dollars back to yen, the range over the past 30 years has been a cost of about 6.5% to a gain of nearly 2%.
Investors can make portfolio modifications to mitigate rising hedge costs. For example, extending fixed income duration (in upward sloping curves) or moving into higher-yielding bonds helps increase yield and offset hedge costs. Investors can also consider removing the hedge (taking active FX risk), or investing in local-currency assets.
Our FX traders buy the foreign currency to pay for the security and simultaneously sell the currency to a value date in the future to hedge the currency risk. The investor is now long the foreign bond and short the FX forward. If the currency value goes down, the investor loses on the security but benefits from the forward—the FX risk is hedged.
To maintain the hedge and avoid exchanging potentially very large amounts of currency on the value date, we generally “roll” forwards as the value date nears. Rolling a forward involves closing out the existing forward and opening a new forward to a new value date. Closing the existing forward generates a profit or loss; on the value date, only the profit/loss associated with that forward is exchanged. Both trades are executed simultaneously using the same spot rate (to avoid crossing the bid/offer spread). The differences in prices are the forward points on the new position.
HYPOTHETICAL EXAMPLE OF HOW WE USE FORWARDS TO HEDGE
During the life of the forward, the size of the unrealized profit/loss is monitored so that we are prepared to raise cash for a loss or invest the proceeds of a profit. In periods of extreme market stress, like the financial crisis, or during times of very large moves, the cash flow requirements can be substantial. Variation margin or collateral may be required for accounts trading under an International Swaps and Derivatives Association (ISDA).
A restricted currency is a currency that cannot be freely traded because it has some form of controls around purchases and sales. The controls are generally imposed by a government. Typically, custodial banks execute spot transactions in restricted currencies on behalf of the client.
An NDF (non-deliverable forward) is a cash-settled forward, typically a restricted currency versus a freely traded currency, most commonly the US dollar. The profit/loss can be determined by the agreed-upon NDF rate at inception of the trade versus the spot rate at the time of settlement (published “fixing rate”). The gain/loss is then settled in the freely traded currency. Among the largest NDF markets are the South Korean won and Brazilian real. We actively trade NDFs.
iBank for International Settlements Triennial Central Bank Survey, data as of April 2016.
This material is provided for informational purposes only and should not be construed as investment advice. Opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Loomis, Sayles & Company, L.P. Investment recommendations may be inconsistent with these opinions. There is no assurance that developments will transpire as forecasted and actual results will be different. Data and analysis does not represent the actual, or expected future performance of any investment product. Information, including that obtained from outside sources, is believed to be correct, but Loomis Sayles cannot guarantee its accuracy. This information is subject to change at any time without notice.
Case studies and other examples are provided for illustrative purposes only. We make no representation that such examples represent any profitable trades.
Currency hedging, like other investment techniques, carries risk. An adviser may decide not to engage in currency transactions if permitted by investment guidelines, and there is no assurance that any currency strategy used will succeed. In addition, suitable currency transactions may not be available in all circumstances and there can be no assurance that an account will engage in these transactions when they would be beneficial. Certain currency transactions also involve counterparty and liquidity risk.