Price moves in the currency markets can be disruptive and lead to large losses with investors and corporations. In general, institutions do not protect themselves against this risk, because the cost of hedging is high. In this post, I try to explain how dynamic hedging improves the cost structure and makes hedging appear indispensable.
Currency risk is incurred, whenever assets or liabilities are denominated in a foreign currency. Liabilities are the opposite of assets and can basically be hedged in the same way as assets. Assets, just as liabilities, can be of any shape or form; they can be financial instruments, fixed assets, such as a house or factory; or an income or payment stream, for example pension receipts or payments for project work. Whenever the foreign currency appreciates, the value of the respective asset increases, whenever the foreign currency drops, so does the value of the asset. Any rise or decline in value of an asset represents volatility and is an incremental contribution to risk. Investors can improve risk adjusted performance, if they can lower risk without reducing return expectations.
The price movements in the currency markets are an important risk factor for assets and liabilities denominated in foreign currency. Currency movements of plus or minus 10 percent in 6 to 12 months are nothing extraordinary. Occasionally currency movements are far bigger and may move by plus or minus 30 percent in only six months. This explains, why in principle there is a lot of interest in neutralizing currency risk through hedging or currency overlay, as professionals call it. There are the following methodologies to hedge currency risk.
Static hedge
The institution hedges its currency exposure by selling the equivalent amount of foreign currency and buying the home currency. The selling of the foreign and buying of the home currency occurs at the exchange rate that is quoted at the time of executing the hedge trade. As long as the hedge stays open, the institution has to pay credit interest on the foreign currency and receives the debit interest on the home currency.
The operational details of the static hedge are the following: it is necessary to setup an account to execute the currency hedge. This involves putting up collateral to fund the hedge. The collateral is the margin capital to fund the hedge and absorb potential losses during the lifetime of the hedge. The collateral is typically roughly 10 percent of the value of the foreign asset. The collateral is used as margin capital for the actual hedge and to offset losses, in case the foreign currency appreciates and the hedge is under water, i.e. the current market price is higher than the price at which the currency was originally sold.
The hedge neutralizes the currency risk because in accounting terms, when summing up the value of the foreign asset and of the hedge, changes in valuation of the foreign asset and the hedge offset each other. A loss incurred on the hedge is compensated by a profit on the foreign asset. If on the other hand the foreign currency depreciates, then the hedge generates a profit that compensates a loss made on the foreign asset. Large institutions hire overlay managers to execute the hedge.
The static hedge can be established through a bank, a specialized market maker in foreign exchange or through a futures contract.
Establishing a hedge is not free of cost, the institution has to allocate funds or provide a credit line that is used as collateral for the margin capital of the hedge. Even though the collateral earns interest, this ties up capital and thus implies an opportunity cost to the overall institution.
Another drawback of a static hedge is that the value of the hedge is as good as the timing of the hedge: when the position was opened and closed. If the institution times its hedge well, it is the big winner, but if it fails to pick the peak of the value of the foreign currency, the profitability of the hedge is disappointing.
Due to the cost of putting up collateral to fund the hedge and the need to have a good timing for the static hedge, institutions have not embraced currency hedging. They prefer to endure the risk of currency movements than to hedge their exposure. This strategy has the benefit that management has a good excuse: if overall performance is below par, they can always blame the currency markets.
Options
Another approach to currency hedging is to buy put options to offset the risk of currency depreciation. A put option gives the buyer a right to sell a defined amount of foreign currency at a specific strike price, typically the current price minus any interest rate differential between the home and foreign currency for the duration of the option. The cost of a put option is high: typically, a put option for one year can cost as much as 10 percent of the underlying asset. So the price depreciation of the foreign asset needs to be at least 10 percent to break even. The cost of put options can be reduced by implementing a more complex option strategy, e.g., by buying a put option and at the same time, selling a call option. Such a strategy adds risk and complexity to the transaction making it more difficult to manage the hedge. Institutions rarely use options to hedge their currency risk because of the cost and complexity.
Combining static hedge with dynamic hedge
At Olsen we have developed a hedging program that overcomes the deficiencies of a static hedge. The program has two components a static hedge and a dynamic hedge. The dynamic hedge buys and sells the foreign currency in tandem with price action in the currency markets: whenever the foreign currency appreciates rapidly, the dynamic hedging program makes incremental sales of the foreign currency and buys the home currency. As soon as the foreign currency starts to drop again, the program closes out these short positions by buying the foreign currency and selling the home currency. If the foreign currency drops further, the program continues to build up the offsetting hedge by buying the foreign currency and selling the home currency.
The dynamic component can in this way take advantage of the many ups and downs in the foreign exchange markets. During the course of one year, the sum of all the up and down movements bigger than 0.05 percent are a whooping 1600 percent for a typical exchange rate after accounting for transaction costs. The price curve with all its up and down movements is the coastline of the exchange rate. The dynamic hedging program takes advantage of the length of the coastline and the temporary price overshoots, which are then reversed, to increase and reduce the total size of the hedge to generate incremental return.
Let me give an example:
If the foreign asset has a value of 100 units, then the static hedge is short 50 units of the foreign currency and long the equivalent amount in home currency. The net exposure of the investor to the foreign currency is then 50 units. In addition to the static hedge, the Olsen program includes dynamic positions that are opened and closed in response to the price overshoots. The dynamic hedge can in an extreme situation, when the foreign currency appreciates rapidly, increase the hedge by selling an additional 50 units of the foreign currency and buying the equivalent of home currency; the hedge is then the same size as the foreign asset. If the reverse happens and the foreign currency drops rapidly, the dynamic hedge starts to buy the foreign currency and incrementally builds up a long foreign currency position that offsets the static hedge. In an extreme situation, the dynamic hedge may be as large as the static hedge thus equivalent to a closeout of the hedge.
The advantage of this approach is that the overall size of the hedge changes dynamically. Whenever the foreign currency appreciates rapidly, the dynamic hedge adds to the overall hedge, whenever the foreign currency drops rapidly, the total hedge size is reduced. By dynamically changing the overall size of the hedge the program generates a profit, which is welcome revenue that can offset the opportunity cost of setting aside margin capital for hedging.
The dynamic hedge is a benefit because it reduces the importance of getting the timing of the static hedge right – if the static hedge was initialized at an inopportune time, when the foreign currency had already dropped, then the dynamic hedge will make up for some of the lost opportunity.
Most importantly, the dynamic hedge increases the size of the hedge. Whenever the foreign currency appreciates; the dynamic hedge reduces the size of the hedge, and whenever the foreign currency depreciates, the dynamic hedge cushions the impact of the price movements of the foreign currency and reduces risk by lowering volatility of the net value of the foreign asset including its hedge. Differen to the option strategy, which costs money, if the price moves do not happen as expected, the dynamic hedging strategy does not cost money because the profits from the dynamic hedge pay for the opportunity cost of the capital dedicated to the hedging strategy.
April 29th, 2010 | Investment, News | RSS feed
Elegant in theory and fantastic if it works in real FX market.
First nice article. But also a naive question, what about if the dynamic hedge just accumulates enormous loss before the price turns around and in the worst case triggers a margin call?
You raise an important point: the static and dynamic hedge require margin capital to fund the positions. If the foreign asset goes up in value, then the static hedge and temporarily also the dynamic hedge will be in a loss. The hedging strategy needs to be set up in such a way that the program has access to sufficient collateral. The details of implementation depend on the specific circumstance of the investor.
Interesting hedge methodology, albeit an apparent solid speculative methodology as well. Thank you for sharing this, I’ve stumbled upon your blog yesterday and it is a real jewel on the internet; the heterogenous market model and seasonality are all concepts I’ve thought about, and I find proofs of those concepts in your publications, which are all amazings. Back to the topic, I dare say you make extensive use of the scaling laws to determine market overshoot, is that right?
Yes, definitely – scaling laws are the backbone of our methodology. They provide a frame of reference for any type of measurement. This is necessary, because the world and the financial markets in particular are ‘dynamic’, where there is no point fixed that could be used as an anchor for model building. Scaling laws are a substitute and represent a dynamic frame of reference.
[...] hedging improves the cost structure and makes hedging appear indispensable.Currency risk [...]Read More… [Source: OlsenBlog] [...]