Perspectives On Currency Management
By: Harry Marmer
Last year was an unusual one for Canadian investors. Our equity market was one of the best performers worldwide and the Canadian dollar had one of its strongest years ever. On the surface, this appears to be good news. However, the downside of these occurrences is that Canadian investors in foreign markets had relatively disappointing results. This did not happen because foreign investments were weak, but because the Canadian dollar was so strong against other currencies. These results led some investors to reexamine their currency hedging strategies. Others even questioned the benefit of global investing.
To Hedge Or Not To Hedge?
In setting currency management policy, investors can select from a range of positions depending on their underlying beliefs and perspectives on return and risk. Investors who hold the singular long-term view that currencies create risk with little return benefit will opt to fully hedge currencies. This view was made popular in the late 1980s due, in part, to a research paper by Andre Perold and Evan Schulman. They argued that in the long term there is a “free lunch” available by fully hedging your portfolio’s currency exposure in that you can reduce risk without reducing return since the expected return of currency hedging is zero.
However, we know that currency hedging can incur costs which will reduce returns. In addition, this purely “risk driven” approach ignores the correlation between currency and local asset classes. To the degree that this correlation is negative, hedging will actually increase risk!
Well-known financial economist Fisher Black, co-developer of the Black-Scholes option-pricing model, had a slightly different twist on how to deal with currencies. He did not believe that expected returns on currencies are zero. Under a number of simplifying assumptions, Black concluded that the optimal hedge ratio is actually 77 per cent. Other practitioners3 have suggested that a hedge ratio of 50 per cent could improve upon both unhedged and fully-hedged solutions.
Unfortunately, Black’s hedge ratio is based on a number of highly restrictive assumptions including no barriers to foreign investing!
However, the message of Black’s analysis – that there is an optimal hedge ratio and it is less than 100 per cent – leaves investors to determine their own hedge ratio.
A more pragmatic approach is to forget about finding the optimal hedge ratio and simply allow your manager to hedge currency risk when he or she thinks it is most appropriate.
Another way to look at the issue of partial hedging is from the perspective of corporate revenues. If revenues benefit from an appreciating Canadian dollar, it is more likely you can afford to hedge.
A newer trend in investment strategies is to consider hiring a separate – or “overlay” – currency manager. The objectives can vary from a focus on generating excess returns to a focus on reducing risk. In the latter case, you are back to using a partial hedge strategy. Issues here include deciding on an appropriate alpha target for the overlay manager and assessing the effectiveness of the expected and realized risk/return advantage versus the costs of implementation.
Unsatisfied with many of the “fuzzy” solutions for calculating the optimal hedge ratio, some pension sponsors may avoid currency hedging altogether.
If your money manager builds currency assumptions into their stock valuations, or actually hedges some of their stock positions, the need to hedge the overall portfolio may be reduced. Further, it is difficult to know which companies have already hedged their own currency risk.
The value of hedging is further diminished by the limits placed on Canadian pension sponsors when investing outside of Canada.
Finally, it has been suggested that currency risk is a wash over the very long term. This position was put forward by David Froot, who argued that since pension sponsors have an infinite investment horizon there was no reason for them to hedge. In fact, given the Canadian dollar’s record as a weaker currency, it may be most profitable not to hedge it at all.
While there is no universal solution for institutional investors addressing currency management, for investors with long-term horizons, remaining unhedged is a pragmatic answer for currencies – like the Canadian dollar – that have tended to slowly depreciate with brief spurts of appreciation.
Harry Marmer is senior vicepresident, institutional investments, at Franklin Templeton Investments.
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