In October, the unfolding of the European crisis was in the focus of market participants. At the European summit a new rescue package for Greece was structured. Governments and private institutions have decided on a haircut for the Greek debt. After the US has enacted the Volcker rule for banks, European banks will have to recapitalize by 106bn EUR and increase their core capital quota to nine percent.

Product profile AF generated 1.18% net profit. The high market volatility in October offered profitable trading opportunities in many of the currencies, in particular CHF, CAD and EUR.

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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.

The most common mistake that a trader makes, is to rush into a position too quickly and to be too aggressive in his opening trade. There is no need to rush into a position and make a big trade, you have all the time in the world. Similar to the practice of serving slow food, I strongly recommend that you temper your natural impulse of trading at a high pace with large positions.

Why? The coast line of the sum of all the up and down movements at a threshold of 0.05% has a length of 1600% for every exchange rate and is similarly long for other financial instruments. With perfect foresight, it would be possible to earn a whooping 1600% in profits per year after paying for all the transaction costs. If in real life a trader earns 5% by just trading his equity with no leverage; he is successful by any standard, if he earns 10% during the course of a year; he literally enters the hall of fame. If you are able to successfully realize 0.6% of the existing profit opportunities, you get into the hall of fame.  Hence, there is no need to rush into a position. There is a near infinity of profitable trading opportunities, choose your battle ground carefully and only open a trade that you believe in.

Why do I stress the fact that you should choose your battle ground carefully and believe in your trade? The reason is simple: Financial markets are fractal, they do not move in straight lines, there is a continuous up and down. Whenever there is a price movement in the opposite direction of your trade, you have no certainty on whether or not this trend will reverse. As you sit there and observe the market, you start to second guess your decision. If you have opened your position hastily, you will soon feel uncomfortable with your trade and will then be inclined to close out your position during such a draw down and then open a trade in the opposite direction. If you do this, your trading will lag behind the market and you will be out of step  just accumulating losses.

Trade in small size

The most common mistake of a non-professional trader is to trade too aggressively and open positions that are far too large. If the position is too large and the market moves temporarily against the trader, he does not have sufficient margin capital to pull his position through and is stopped out. He is then forced to close out his position at the worst possible moment during a temporary down tick.

We human beings are inclined to open positions that are too large because we are not very good in forecasting the size of tail events. Just try and remember when you last dropped a glass and had to collect the glass splinters. I am sure that you were surprised at how widely dispersed the glass splinters were. By analogy, the same is true for market moves. The biggest market moves are far bigger than we would guess. For this reason, it is important to have far more margin capital available than is typical. I conjecture that the most successful traders excel because they manage to keep exposure very low and rarely open positions larger than four times leverage (four times leverage means that the trader has opened positions four times the size of his equity).

You can afford to trade in small size and not give away potential profit because the coastline of each instrument is so long and there are many different instruments that you can choose between. After all, if you are stopped out and have lost your capital, you have lost your car and are out of the race. So it is paramount to conserve your capital.

Currency investing is different. Compared to investing in stocks or bonds, its time horizons are greatly compressed (meaning that the effects of trading volume plus liquidity plus the perceived value of a currency can present greater opportunities for gain and loss in one day that you might expect on conventional equity and fixed income markets in one year).

The equality of gains and losses: conventional investing is based on the notion of one-sided ownership: you buy (go long)…you hold…you sell. Currency markets, in contrast, place equal value on selling (going short); this is reflected in the very nature of every currency transaction because you must buy and sell a pair: you cannot take a one-sided position. As a practical matter, this means that opportunities exist regardless of whether “the market” is rising, falling, or moving sideways…

Clicking here will retrieve an Acrobat version.

Clicking here will retrieve an Acrobat version.

Standard risk metrics overlook or average away the impact of extreme events. To evelop and maintain viable investment strategies, Olsen expands the concept or risk-budgeting to allow for drawdowns and to forestall the suddenly fatal effects of margin requirements. This article promotes the combined application of the Calmar Ratio and a new metric devised by Olsen: ExposureFactor (the cost—in terms of leveraged risk capital—required to earn an average annualized return of 1%). The focus here is on strategic engineering of leverage to reduce risk and realize excess return. Included are critiques of some current risk metrics and an explanation of Olsen’s proprietary risk-reducing investment methodology…

Clicking here will retrieve an Acrobat version of the illustration.