Turning Bad Currency Exposures into Good Risks

(March 13, 2014) — Combining currency hedging and active strategies could help institutional investors generate high returns with lower risk and volatility, according to a study.

According to the paper’s authors—Momtchil Pojarliev of Fischer Francis Trees & Watts, Richard Levich of the New York University Stern School of Business, and Ross Kasarda of the Virginia Retirement System—the key is to reduce risk from a hedging program and take on other risks such as an unfunded currency alpha mandate.  

“Structuring the hedging and alpha programs in tandem provides a holistic approach that can be managed as a centralized currency strategy,” the authors said. The approach addressed risk and return simultaneously.

Currency overlay programs offset portfolios’ foreign exchange exposure, theoretically allowing investors to lower volatility with minimal impact on returns. Currency alpha strategies work in the opposite direction to increase returns with little effect on volatility by adding currency exposures.

“Both currency hedging and currency alpha have the potential to improve the Sharpe ratio of the typical institutional portfolio,” the authors wrote. “Currency hedging favorably impacts the denominator by reducing the volatility of the portfolio with little impact on the returns (numerator). Currency alpha favorably impacts the numerator with little impact on the volatility.”

The research observed various portfolios with differing foreign currency exposures and hedging ratios against a benchmark 60/40 portfolio that was 50% hedged in non-US equities. The sample period ran about 25 years—from January 1998 to March 2013.

By varying the hedging ratios, the authors found the volatility dampening effects were greatest amid bearish equity markets. “In those periods, the decline in the volatility is much more substantial, reaching 88 basis points over all 40 months with negative equity returns when compared to a decline of only 52 basis points for a full hedge in all 303 sample months.”

The study then allocated 20 basis points of the risk budget to currency alpha and increased the hedging ratio to 70% in an effort to judge the success of combining the two programs and observe changes to the Sharpe ratio. It was then invested in four modeled alternative portfolios—the currency beta portfolio, the beta-grazer portfolio, the alpha-hunter portfolio, and the alpha-generator portfolio.

All four outperformed the benchmark portfolio, the paper found, and saw a decline in volatility ranging from 24 to 38 basis points. The alpha-generator portfolio—allocated to managers with the highest alpha—performed the best, with “results in excess returns of 39 basis points with no extra volatility.”

“Recent research has demonstrated the traditional currency investing strategies (carry, trend, and value) have offered attractive risk-adjusted returns, and that some currency managers are even able to generate true alpha in excess of the returns generated through exposure to the traditional strategies,” the paper said.

In the extreme case of a 100% hedge ratio and 100% allocation to alpha-generators, the study found volatility fell to 10.46% from 10.71% while returns climbed from 4.01% to 7.7%. The Sharpe ratio also doubled that of an unhedged portfolio with no allocation to alpha generators.

“To avoid potential ‘ugly’ performance consequences, ‘bad’ currency exposure embedded in global equity and bond holdings should be replaced with ‘good’ currency risk associated with a currency alpha mandate,” the authors argued.

Read the full paper here. 

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