The global economy could continue to surprise on the upside but the impact on the medium-term path of equity prices would be weaker. Amar Reganti looks for alternative sources of capital gains and income streams within a moribund fixed-income asset class.

November Magazine By Martin Steward. The environment since makes the case for dynamic hedging. Martin Steward asks which strategies and which instruments are best-suited to the risk-management process. Most institutional investors get the argument for currency hedging, especially as the de-risking trend of the past years has made unwanted currency exposure a greater and more visible part of total portfolio risk, at the margins.

There was always some resistance to that idea in the UK and the rest of Europe, and when a number of currency managers ran into difficulty during the financial crisis, dynamic hedging was dealt a blow — leaving us with the fully-hedged solution described by Kelly.

Gavin Francis, a managing director in client currency portfolio management at Insight Investment , concurs that European currency-hedging tends to be done passively. At State Street Global Advisors , head of currency management Colin Crownover similarly acknowledges that the big move of the past 10 years has been from active hedging to separating hedging and alpha-generating processes.

In this respect, makes rather than breaks the case for active hedging: Crownover says that investors are taking one of two routes in this return to dynamic risk management. Some are trying to build optionality into their hedging programme — ways to capture big appreciations in their base currencies while opting out of scrambling for cash when there are big moves the other way.

SSgA tilts towards what it counts as under-valued currencies, hedging out those that are over-valued. This might sound like the sort of active management that investors have rejected.

But Crownover makes the case for its risk reduction properties with two points. First, the value tilt is entirely systematic, rather than based on forecasting. Second, the primary objective of the value tilt is not to add value but to provide tail-risk protection.

Nonetheless, a value tilt can introduce meaningful risk: Heiden observes that short-term basis risk matters even to long-term investors, not only because they face regular reporting requirements, but because the biggest currency moves tend to happen very suddenly. At Insight, which also favours the optionality route, Francis makes much the same point. So investors arrive at a recognition that the two key problems they want to solve with hedging are: For the first problem, as we have discussed, optionality seems like a good solution — it is short-term oriented and systematic.

For the second, FX options seem, on the face of it, like a good instrument. An FX option offers exposure to the strengthening of your base currency without saddling you with the exposure to the weakening of your base currency that results in those unpredictable cash flows.

In exchange, you pay an up-front premium determined by the implied volatility of the exchange rate. So the trade-off is ultimately between certainty around your cash flows and the cost of that certainty. Is it worth it? An option priced at fair value is one where the accumulated premia offset the accumulated pay-off, argues James Wood-Collins, CEO at Record Currency Management.

Hedging With Options

Neil Staines, head of trading at the ECU Group, which offers both return-seeking and currency-hedging programmes, cautions against following this efficient-markets critique unquestioningly.

He points out that the longer the tenor of an FX option is, the more its valuation is driven by the interest-rate differentials in the currency pair, rather than the simple volatility of the exchange rate. If it is, the option can be incredibly cheap. There are definitely situations where you can lock in better gains and cheaper optionality by using interest-rate differentials or the different volatilities in one tenor versus another — but assessing that is, by definition, quite a complex process.

However, even if options structures of varying complexity can reduce the performance drag associated with cash-flow certainty to within acceptable limits, there remains a question even against that assumption of cash-flow certainty. The argument in favour of options is that once they are in place you know your costs. In addition, options can prove pretty inflexible should you need to change your hedge.

An investor faces a choice between writing a corresponding option or entering into a negotiation with its counterparty to amend or close positions — probably at a punitive cost. So FX options themselves may not be the optimal way to implement optionality in an FX hedging programme. A number of managers choose, instead, to replicate option pay-offs using trend-following currency-forward strategies — increasing the hedge ratio once the base currency has entered an appreciating trend, and decreasing back towards the hedge ratio benchmark once it has entered a depreciating trend.

Record and Insight hedge in this way, and a momentum strategy underlies the programme Berenberg runs for its clients, too. Record splits the total potential hedge into 12 rather than five, and its 12 trigger points for hedging or de-hedging are set by implementing a new forward position each month at the prevailing spot rate. This means that, at any one time, there are 12 different exchange rates acting as triggers for each currency pair the client wants to hedge. This sensitivity to trend strength is vital because it determines the costs of the programme — the equivalent to the up-front premium that you pay for an option.

With a forwards-based trend-following programme, you achieve a similar result as with an option, in that you get protection against big cash-flow demands from significant appreciation of your base currency.

But, because the costs depend upon how your programme responds to realised currency volatility, your cash flows will always remain uncertain. Put simply, a long period of range-trading in a currency pair which is choppy enough to switch triggers on or off without establishing a decent trend will result in higher cost for little hedging benefit.

There are ways of managing these costs that are certainly easier than building complex offsetting option structures — Record will over-ride new trigger points if they would be placed to close to existing ones, for example.

But advocates of systematic trend-following say that the costs will tend, in any case, to be lower than those associated with options.

Hedge

The first of these is the costs associated with rolling into new option contracts. The second is that a trend-following strategy, by definition, responds to, and therefore its trading costs are defined by, realised volatility, whereas options are priced according to implied volatility — and realised volatility tends to be lower than implied. Wood-Collins adds another explanation.

Most currency pairs do exhibit momentum, and anything that exhibits momentum also exhibits higher volatility over longer time horizons. Some remain sceptical of the optionality-based approach to hedging in general. Crownover says that SSgA does some option-replication in its active strategies, but does not do so in any passive or dynamic hedging programmes.

In fact, it can only be so if one genuinely feels there is no benefit gained from building optionality into a currency hedge — a position that is difficult to sustain.

When it comes to risk management, pure performance is not the aim of the strategy.

The aim is to make sure the programme is triggered when there are big, significant trends in the risks you are exposed to. Those risks are twofold: Passive hedging leaves you fully exposed to one or the other, or sub-optimally exposed to both.

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