Derivatives & Risk Management Currency Management: An Introduction

Learning Module: 3

1. INTRODUCTION

Worldwide financial system integration, new investment Foreign exchange risk tends to have a substantial
products, deregulation, and better communication and impact on investment returns and risks because
information networks have widened global investment exchange rates are highly volatile, particularly in the

Stanley Notes™ 2 0 2 5
opportunities for investors. short-to-medium term. Hence, foreign exchange (or
currency risk) in global portfolios must be managed
Besides higher-expected-return investments, these new effectively.
investment opportunities also increase portfolio
diversification opportunities.

However, they also create several challenges regarding

measuring and managing foreign exchange risk
associated with foreign-currency denominated assets.

2. FOREIGN EXCHANGE CONCEPTS

Market width = Bid-offer spread = Offer – Bid

1. Spot Markets

• When a client sells base currency, it is known as

Exchange rate “hit the bid”.
An exchange rate refers to the price of one currency • When a client buys base currency, it is known as
(price currency) in terms of another currency (base
“pay the offer”.
currency) i.e. number of units of one currency (called
the price currency) that can be bought by one unit of
another currency (called the base currency). 2. Forward Markets

P/ B quote refers to price of one unit of the base

Unlike spot rates, forward contracts are any exchange
currency “B” expressed in terms of the price currency “P”
rate transactions that occur with settlement period
i.e. the number of units of currency P that one unit of
longer than the usual “T + 2” settlement for spot delivery.
currency B will buy.
Typically, forward exchange rates are quoted in terms of
points (called pips).
E.g. USD/EUR exchange rate of 1.356 means that 1 euro
will buy 1.356 U.S. dollars
Points on a forward rate quote = Forward exchange rate
quote - Spot exchange
• Euro is the base currency; rate quote
• U.S. dollar is the price currency.
These points are scaled to relate them to the last
IMPORTANT TO NOTE: decimal in the spot quote.
When the price currency appreciates (depreciates), it
Converting forward points into forward quotes:
means depreciation (appreciation) of the exchange
rate quote. To convert the forward points into forward rate quote,
forward points are scaled down to the fourth decimal
Bid rate place in the following manner:
The price at which the bank (dealer) is willing to buy the
𝐅𝐨𝐰𝐫𝐚𝐝 𝐩𝐨𝐢𝐧𝐭𝐬
currency i.e. number of units of price currency that the Forward rate = Spot exchange rate + 𝟏𝟎,𝟎𝟎𝟎
client will receive by selling 1 unit of base currency to a
Forward premium/discount (in %) =
dealer. 𝐬𝐩𝐨𝐭 𝐞𝐱𝐜𝐡𝐚𝐧𝐠𝐞 𝐫𝐚𝐭𝐞5(𝐟𝐨𝐫𝐰𝐚𝐫𝐝 𝐩𝐨𝐢𝐧𝐭𝐬/𝟏𝟎,𝟎𝟎𝟎)
-1
𝐬𝐩𝐨𝐭 𝐞𝐱𝐜𝐡𝐚𝐧𝐠𝐞 𝐫𝐚𝐭𝐞
Ask or offer rate
The price at which the bank (dealer) is willing to sell the To convert spot rate into a forward quote when points
currency i.e. number of units of price currency that the are represented as %,
client must sell to the dealer to buy 1 unit of base
currency. Spot exchange rate × (1 + % premium)
Spot exchange rate × (1 – % discount)
E.g. USD/EUR of 1.3648/1.3652 means dealer is willing to
buy 1 EUR at USD 1.3648 and sell 1 EUR for USD1.3652.
Derivatives & Risk Management Currency Management: An Introduction
Learning Module: 3

NOTE:
For yen, forward points are scaled up by two decimal 3. FX Swap Markets
places by multiplying the forward point by 100.
FX swap transaction involves buying (selling) the base
• Point is positive when the forward rate > spot rate. currency in the spot and selling (buying) in forward.
o It implies that the base currency is trading at a These two offsetting and simultaneous transactions are
forward premium and price currency is trading referred to as the “legs” of the swap.
at a forward discount.
• Point is negative when the forward rate < spot FX swaps can be used to “renew” outstanding forward
rate. contracts (i.e. to roll them forward) as they mature. FX
o It implies that the base currency is trading at a swaps represent the largest single category within the
forward discount and price currency is trading global FX market.
at a forward premium.
FX Swaps’ similarity and differences with Currency Swaps
IMPORTANT TO NOTE:
Similarity: At swap initiation, exchange of principal
• To sell the base currency means calculating bid amounts in different currencies.
rate.
• To buy the base currency means calculating offer Difference: Unlike currency swaps, FX swaps have no
rate. interim interest payments and are of much shorter term.
• When the currency in which the investor has long
(short) position subsequently appreciates Types of FX swap:
(depreciates) in value, there will be a cash inflow
(outflow). a) Matched Swap: In a matched swap, the base
currency amounts of the two legs are equal in size.
Due to equal legs, it consists of exactly offsetting
Mark-to-market value on the position = PV of cash flow transactions. As a result, common spot exchange rate
(usually mid-market spot exchange rate) is applied to
NOTE: both legs of the swap transaction.
The currency of the cash flow and the discount rate
must match. b) Mismatched Swap: In a mismatched swap, the base
currency amounts of the two legs are unequal in size.
Example: Since the mismatched swap does not involve exactly
offsetting transactions, the pricing of FX swap will
Suppose a market participant bought GBP 10,000,000 for depend on the difference in trade sizes between the
delivery against the AUD in six months at an “all-in” two legs of the transaction. That is, the spot rate
forward rate of 1.6000 AUD/GBP. quoted as the base for the FX swap will be adjusted
for mismatched size.
Assume the bid-offer for spot and forward points three
months prior to the settlement date are as follows:
4. Currency Options
• Spot rate (AUD/GBP) 1.6211/1.6214
• Three-month points 135/140 Common currency options in FX markets, which are
• 3-month AUD LIBOR = 4.50% (annualized) broadly used for risk management and speculative
Forward rate = 1.6211 + 135/10,000 = 1.6346 purposes are:

• Vanilla options (simple call and put options

• After three months, the market participant sold
• Exotic options (options with a variety of features)
GBP 10,000,000 at an AUD/GBP rate of 1.6346.
Hence at settlement, GBP 10,000,000 amounts will
Compared to simple vanilla options, exotic options
net to zero.
include features which make them highly flexible risk
• However, since the forward rate has changed, management tools.
the AUD amounts will not net to zero.

AUD cash flow at settlement date

= (1.6346 – 1.6000) × 10,000,000
= AUD346,000.

Mark-to-market value on the position

:;<=>?,@@@
= EF
A5@.@>C D I
GHF
= AUD 342,150.80
Derivatives & Risk Management Currency Management: An Introduction
Learning Module: 3

3. CURRENCY RISK AND PORTFOLIO RETURN AND RISK

Sum of weights must be = 1. However, if short selling is

1. Return Decomposition
allowed, some weights (wi)
can be < 0.
Domestic assets are assets denominated in the investor’s
domestic currency (or home currency). Domestic
2. Volatility Decomposition
currency is the currency in which the portfolio valuation
and returns are reported.
Total risk of the domestic-currency returns = S.D.
Foreign assets are assets denominated in foreign
currency. Unlike domestic assets, return on foreign assets = 𝜎 (𝑅MN )
is exposed to foreign exchange risk. ≈ P𝜎 Q (𝑅RN ) + 𝜎 Q (𝑅RT ) + [2 × 𝜎 × (𝑅RN ) × 𝜎 × (𝑅RT ) × 𝜌(𝑅RN , 𝑅RT )]

Foreign currency return is the return of the foreign asset

• When there is no exchange-rate risk, σ2 (RDC) = σ2
measured in terms of foreign-currency. E.g. if Euro
(RFC).
denominated bond increased by 5%, measured in Euro,
• When exchange rate movements are negatively
the foreign-currency return to the U.S. zone-domiciled
correlated with variances of each of the foreign-
investor will be 5%.
currency returns, the overall portfolio’s risk reduces
through diversification effects.
Domestic-currency return:
• Similarly, when two foreign assets have a strong
positive return correlation with each other, short
RDC = (1 + RFC) (1 + RFX) – 1
selling can provide significant diversification
Where, benefits for the portfolio.
RDC = domestic currency return (in %)
RFC = foreign-currency return (in %) Variance and correlation measures vary depending on
RFX = % change of the foreign currency against the the time period used for estimation and they may
domestic currency i.e. appreciation or change over time.
depreciation of the foreign currency.
Therefore, historical volatility and correlation measures
may not represent to be a good predictor for future
• It must be stressed that in the above calculation,
volatility and correlation measures.
the foreign exchange must be quoted with
“domestic” currency as the price currency.
For expected values of volatility and correlation
• RFX will not always be equal to %∆SP/B.
measures, survey and consensus forecasts can be used
but they are also sensitive to sample size and
When RFC and RFX are small, then the domestic currency composition and are not always available on a timely
return can be calculated as follows: basis.

RDC = RFC + RFX

The domestic currency return on a portfolio of multiple Practice: Example 1 from the CFA
foreign assets will be equal to Institute’s Curriculum.
n
RDC = å w (1 + R )(1 + R ) - 1
i =1
i FC ,i FX ,i

Where,
RFC = Foreign currency return on the i-th foreign asset
RFX = Appreciation of the “i-th” foreign currency against
the domestic currency. The foreign exchange
must be quoted with “domestic” currency as the
price currency.
wi = Portfolio weights of the foreign currency assets i.e.

Weight of i-th foreign asset = Value of i-th foreign

currency asset / Total
domestic-currency value of
the portfolio
Derivatives & Risk Management Currency Management: An Introduction
Learning Module: 3

STRATEGIC DECISIONS IN
4.
CURRENCY MANAGEMENT: OVERVIEW

1. The Investment Policy Statement expected foreign-currency asset risk-return trade

off.
iii. Afterwards, choosing the desired currency
IPS specifies the following points: exposures for the portfolio and the permitted
degree of active currency management.
• The general objectives and risk tolerance of the
investment portfolio
• The investment time horizon
• The ongoing income/liquidity needs of the 3. Choice of Currency Exposures
portfolio (if any)
• Benchmarks used to evaluate portfolio i) Diversification Considerations
performance
• The limits on the type of trading policies and tools Diversification considerations depend on various factors,
(i.e. leverage, short positions, and derivatives) that including:
can be used.
1) Investment time horizon: In the long-run, exchange
rates revert to historical means or their fundamental
The currency risk management policy is a sub-set of the
values i.e. expected %∆S = 0 in the long-run. Hence,
aforementioned portfolio management policies within
adding unhedged foreign-currency exposure to a
the IPS. It specifies the following points:
portfolio will have no effect on portfolio returns and
return volatility. This implies that currency risk is lower in
• Target proportion of currency exposure to the the long run than in the short run; and the investor
passively hedged with a very long time horizon and limited liquidity
• Acceptable degree of active currency needs can forgo currency hedging and its associated
management costs.
• Frequency of hedge rebalancing
• Benchmarks used to evaluate currency hedge
• It must be stressed that when an investor forgoes
performance; and
currency hedging, then he/she must also use an
• Hedging tools permitted (types of forward and
unhedged portfolio benchmark index. In addition,
option contracts)
if currencies continue to drift away from the fair
value mean reversion over a long period of time,
2. The Portfolio Optimization Problem then the investor should use some form of
currency hedging.
• In the short-run, currency movements can have a
In practice, it is difficult to jointly optimize all of the
substantial impact on the short-run returns and
portfolio’s exposures (over all currencies and all foreign-
return volatility. Therefore, the investor with a short
currency assets) simultaneously as it requires investors to
horizon and greater liquidity needs should
have a market opinion for each of the RFC,i, RFX, σ (RFC,i), σ
implement currency hedging.
(RFX,i) and ρ (RFC,i, RFX,i) as well as for each of the ρ (RFC,i,
RFC,j) and ρ (RFX,i, RFX,i).
2) Asset composition of the foreign-currency asset
Therefore, it is preferred to establish asset allocation with portfolio: If a foreign-currency portfolio comprises of
currency risk by: two assets that have negative return correlation with
each other, then the investor can diversify his/her
portfolio and reduce domestic-currency return risk by
i. First removing the currency risk by hedging foreign
assuming some currency exposure.
currency asset returns so that currency
movements will have no effect on the portfolio’s
domestic-currency return; as a result, Generally, the correlation between foreign currency
returns and foreign currency asset returns tends to
RFX = 0 be greater for fixed-income portfolios than for
Domestic-currency return (RDC) = Foreign-currency equity portfolios.
return (RFC)
Domestic-currency return risk [σ2 (RDC)] This implies that there are no diversification benefits
= foreign-currency return risk [σ2 (RFC)] from currency exposures in foreign currency fixed-
income portfolios and therefore, currency risk in a
ii. Then, selecting a set of portfolio weights (wi) for fixed-income portfolio should be hedged.
the foreign-currency assets that optimize the
Derivatives & Risk Management Currency Management: An Introduction
Learning Module: 3

ii) Cost Consideration c) Forward contracts’ “Roll-over” costs associated

with using FX swaps to maintain the hedge. These
Although currency hedge may reduce the volatility of
costs increase the volatility of the investor’s cash
the domestic mark-to-market value of the foreign
accounts.
currency asset portfolio, currency hedging involves cost.
d) Various overhead costs: Currency hedging requires
Hence, the portfolio manager must balance the benefits
maintaining the necessary administrative
and costs of hedging.
infrastructure for trading (i.e. personnel and
technology systems). Also, investor may have to
There are two forms of Hedging costs i.e.
maintain cash accounts in foreign currencies to
settle foreign exchange transactions.
1) Trading costs: These include:
a) Bid-offer spread offered by banks: Maintaining a 2) Opportunity costs:100% hedging involves forgoing any
100% hedge and frequent rebalancing of hedge favorable currency rate moves. Hence, to avoid such
ratio involves substantial trading costs in the form of opportunity costs, portfolio managers prefer to hedge
spread. only the larger adverse movements that can
b) Up-front premiums on currency options: Buying considerably affect the overall domestic-currency
currency options for portfolio hedging requires returns of the foreign currency asset portfolio.
payment of up-front premiums. If the options expire
out-of-the-money, this is an unrecoverable cost.

STRATEGIC DECISIONS IN CURRENCY MANAGEMENT:

5.
SPECTRUM OF CURRENCY RISK MANAGEMENT STRATEGIES

Approaches to Currency Hedging: The approaches to currency exposures within the specified limits (e.g. a
currency management used by portfolio managers vary manager may be allowed to keep the hedge ratio
depending on investment objectives, constraints and within 95% to 105%).
views about currency markets.
• The primary goal of discretionary hedging
1. Passive Hedging approach is to minimize the currency risk of the
portfolio; whereas, the secondary goal is to
enhance overall portfolio returns by taking some
In passive hedging approach, portfolio’s currency
directional opinions on future exchange rate
exposures are kept close (if not equal) to those of a
movements.
benchmark portfolio, which is usually, a “local currency”
index based only on the foreign-currency asset return
with no currency risk*. 3. Active Currency Management

• Passive hedging is a rule-based approach as it In active currency management, the portfolio manager
does not allow portfolio manager any discretion can take positional views on future exchange rate
with regard to currency management. Essentially, movements, but, within allowed risk limits. The
the goal of passive hedging is to minimize performance of the manager is benchmarked against a
tracking errors against the benchmark portfolio’s “neutral” portfolio.
performance.
• Passive hedges are not static and are rebalanced
• Unlike discretionary hedging, the primary goal of
on a periodic basis (as guided by IPS) in response
active currency management is to generate
to changes in market conditions. In case of
positive active return (alpha) by taking currency
extremely large exchange rate movements, intra-
risk.
period rebalancing may be allowed.
• In the short run, there are pricing inefficiencies in
currency markets, which provide opportunities to
*some benchmark indices may have foreign exchange generate positive active returns through active
risk. currency trading.

2. Discretionary Hedging
4. Currency Overlay

Like passive hedging approach, the neutral position for

Currency overlay involves outsourcing currency risk
the discretionary hedging is to have no material
management to a firm specializing in FX management.
currency exposures; but unlike passive hedging, in
Currency overlay programs can be of two types:
discretionary hedging the portfolio manager has some
limited discretion with respect to selecting portfolio’s
i. Directional view currency overlay program: In this
currency risk exposures and is allowed to manage
approach, the externally hired* currency overlay
Derivatives & Risk Management Currency Management: An Introduction
Learning Module: 3

manager is allowed to take directional views on • A portfolio manager may either use several
future currency movements (with predefined limits). currency overlay managers with different styles or
may use fund-of-funds (where the hiring and
ii. Fully passive currency overlay program: It involves management of individual currency overlay
mandating the externally hired* currency overlay managers is delegated to a specialized external
manager to implement a fully passive approach to investment vehicle).However, it must be stressed
currency hedges. This approach is preferred to use that currency alpha mandate should have
when a client seeks to hedge all the currency risk. minimum correlation with both the major asset
classes and the other alpha sources in the
• To separate the hedging (currency “beta”) and portfolio. Also, the portfolio manager must
currency alpha generating function, an external periodically monitor or benchmark the
currency overlay manager can be added to the performance of the currency overlay manager.**
fully-hedged (or with some discretionary hedging
internally) portfolio. Like alternative assets, adding *Some large, sophisticated institutional accounts may
currency overlay to the portfolio (FX as an asset have in-house currency overlay programs.
class) tends to improve the portfolio’s risk-return **Various indices are available that track the
profile by providing diversification benefits and/or performance of the investible universe of currency
by adding incremental returns (alpha). Currency overlay manager.
overlay manager is quite similar to an FX-based
hedged fund.
• When currency overlay considers the foreign Practice: Example 2 from the CFA
exchange as a separate asset class, then the Institute’s Curriculum.
currency overlay manager can take FX exposures
in any value-adding currency pair irrespective of
the underlying portfolio.

STRATEGIC DECISIONS IN CURRENCY MANAGEMENT:

6.
FORMULATING A CURRENCY MANAGEMENT PROGRAM

At strategic level, the portfolio manager should use a • Financial markets are volatile and risky;
more fully-hedged currency management approach • The beneficial owners and/or management
when: oversight committee have doubts regarding the
expected benefits of active currency
• Portfolio has short-term investment objectives; management;
• Beneficial owners of the portfolio are risk averse
and suffer from regret aversion bias; Similarly, portfolio manager should allow more currency
• Portfolio has immediate income and/or liquidity overlay in determining the strategic portfolio positioning
needs; when currency overlay is expected to generate alpha
• A foreign currency-portfolio has fixed-income that is uncorrelated with other assets of alpha-
assets; generation programs in the portfolio.
• Hedging program involves low costs;

ECONOMIC FUNDAMENTALS, TECHNICAL ANALYSIS

7.
AND THE CARRY TRADE

Tactical decisions involve active currency management. Active Currency Management Based on
1.
To implement active currency management, the Economic Fundamentals
portfolio manager needs to have views on future market
prices and conditions.
This method involves estimating the “fair or equilibrium
value” for the currency to predict future currency
Unfortunately, there is no formula or method available to
movements because it assumes that in the long-run, the
precisely forecast exchange rates (or any other financial
prices). spot exchange rates will converge to their long-run
equilibrium (fair) value.
Methods used for forming market views/opinions:
However, the timing and path of convergence to this
long-run equilibrium depend on various short-to-medium
term factors. The real exchange rate movements over
shorter-term horizons depend on movements in the real
Derivatives & Risk Management Currency Management: An Introduction
Learning Module: 3

interest rate differential between countries of base and 200-day moving average, it gives a signal of
price currencies as well as movements in risk premiums. price “break out” point.

All else equal, the base currency’s real exchange rate

should appreciate when:
Limitations of technical analysis:

• Its long-run equilibrium real exchange rate

• Technical indicators lack the intellectual
increases;
underpinnings provided by formal economic
• Either its real or nominal interest rates increase,
modeling.
leading to increase in demand for the base
• Technical analysis is based on rules that require
currency country;
subjective judgment.
• Expected foreign inflation increases, leading to
• Technical analysis is less useful in trendless market.
depreciation of foreign currency;
• The foreign risk premium increases, leading to
decrease in demand for foreign assets; Active Currency Management Based on the
3.
• Currently, base currency is below its long-term Carry Trade
equilibrium values;
Carry trade is a strategy of borrowing in low-yield
Limitations of macro-economic fundamentals model: currencies in order to invest the loan proceeds in high-
yield currencies. According to uncovered interest rate
parity (assuming base currency in the P/B quote as the
• It is very difficult to model the changes in different low-yield currency),
factors over time and their effects on exchange
rates. % change in the spot exchange rate (%∆SH/L)
• It is very difficult to model movements in the long- = Interest rate on high-yield currency (iH) – Interest rate
term equilibrium real exchange rate. on low-yield currency (iL)

Active Currency Management Based on • Positive value of %∆SH/L means depreciation of the
2.
Technical Analysis high-yield currency. If uncovered interest rate
parity holds, high (low) yielding currency tends to
Technical analysis assumes that exchange rates are depreciate (appreciate). This implies that forward
driven by market psychology rather than economic rate should be an unbiased predictor of future
factors (i.e. interest rates, inflation rates, or risk premium spot rates. However, in reality, forward rate is a
differentials). biased predictor of future spot rates.

According to technical analysis, historical price patterns

The carry trade strategy is equivalent to trading the
in the data already incorporate all relevant information
“Forward Rate Bias”. A forward rate bias refers to selling
of future price movements and these historical price
currencies trading at a forward premium and buying
patterns tend to repeat.
currencies selling at a forward discount.
Therefore, in a liquid, freely traded market the historical
𝐹[/\ − 𝑆[/\ 𝑖[ − 𝑖\ ∗
price data can be used to identify overbought/oversold =_ c
level of the market, to predict support (indicating 𝑆[/\ 1 + 𝐼\
clustering of bids) and resistance (indicating clustering of *Interest rates will be adjusted for time periods e.g. if it is
offers) levels in the market, and to confirm market trends semi-annual, then it will be divided by 2.
and turning points.
• When interest rate on base currency < (>) interest
• Technical analysis helps market participants to rate on price currency, the base currency will
determine where market prices WILL trade; trade at a forward premium (discount). In other
whereas fundamental analysis helps market words, a high (low)-yield currency implies trading
participants to determine where market prices at a forward discount (premium).
SHOULD trade.
• Technical analysis uses visual clues for market In carry trade, the investor can earn gain in the form of
patterns as well as quantitative technical risk premium for assuming currency risk (i.e. carrying an
indicators. Example of technical indicators include unhedged position).
o 200-day moving average of daily exchange
rates: When 200-day moving average > current The carry trade is a leveraged position as it involves
spot rate, it indicates that resistance level lies borrowing in the low-yielding currency (typically low risk
above the current spot rate. currencies i.e. USD) and investing in the high-yielding
o 50-day moving average and 200-day moving currency (typically higher risk i.e. emerging market
average: When the 50-day moving average > currencies). Therefore, the returns for carry trade are
negatively distributed.
Derivatives & Risk Management Currency Management: An Introduction
Learning Module: 3

• The lower the volatility of spot rate movements for investment currencies can be equal weighted or
the currency pair, the more attractive the carry weights can be based on trader’s market view of
trade position. Also, these carry trades are the expected movements in each of the
dynamically rebalanced with the changes in exchange rates, their individual risks and the
market conditions. expected correlations between movements in the
• The carry trade may use multiple funding and currency pairs.
investment currencies. Weights of funding and

ACTIVE CURRENCY MANAGEMENT:

8.
BASED ON VOLATILITY TRADING

unanticipated exchange rate volatility.

Volatility Trading: Volatility trading involves using option However, taking long position in the option
market to formulate views regarding distribution of future exposes an investor to the time decay of the
exchange rates rather than their levels. Taking an option option’s time value.
position exposes the trader to various Greeks/risk factors
e.g.
Strategies of Volatility trade:
• Delta: Delta shows the sensitivity of the currency a) Long Straddle: Long at-the-money put option (with
option price (premium) to small changes in the delta = -0.5) + Long at-the-money call option* (with
spot exchange rate. It indicates price risk. delta = +0.5).So that the net delta = 0. It is preferred to
o Delta Hedging: It involves hedging away the use in more volatile markets.
option position’s exposure to delta or price risk b) Short Straddle: Short at-the-money put option (with
using either forward contracts or a spot delta = +0.5) + Short at-the-money call option* (with
transaction. By hedging delta exposure, the delta = -0.5). So that the net delta = 0. It is preferred to
trader has exposure only to the other Greeks. use in more stable markets.
c) Long Strangle: Long out-of-the-money put option +
Net delta of the combined position = Option delta + Long out-of-the-money call option*. This strategy is
Delta hedge relatively cheaper than long straddle because cost of
Size of Delta hedge (that would set net delta of the out-of-the-money options is low. As a result, strangle
overall position to zero) = Option’s delta × Nominal size would have a more moderate risk-reward structure
of the contract than that for a straddle.

NOTE: NOTE:
Spot delta = 1.00. Spot’s exposure to any other of the Delta and Vega are referred to as “Greeks” of option
Greeks = 0; forward contracts have high correlation with pricing.
the spot rate. *both put and call options have same expiry date and
same degree of being at or out-of-the-money.
Vega: Vega shows the sensitivity of the currency option
price (premium) to a small change in implied volatility. It Like currency overlay program that manages the
indicates volatility risk. Volatility is neither constant nor portfolio’s exposure to currency delta, portfolio manager
completely random; rather, it depends on various can use volatility overlay program that manages the
underlying factors, both fundamental and technical. In portfolio’s exposures to currency Vega (i.e. portfolio’s
fact, volatility changes in a cyclical manner. exposures to changes in currencies’ implied volatility)
and may also seek to earn speculative profits.
• Volatility trading (Vega): Volatility trading involves
expressing a view about the future volatility of Generally, changes in volatility are positively correlated
exchange rates but not their direction. with directional movements in the price of the
o Speculative volatility traders prefer to take net- underlying. A trader may have joint market view on
short volatility positions when market conditions Vega and delta exposures.
are expected to remain stable. The option
premiums received by option writers can be • Deltas for puts range from -1 to 0.
considered as a risk premium for assuming • OTM puts have deltas between 0 and -0.5.
volatility risk. The option premium represents a • ATM puts have delta = -0.5.
steady source of income under “normal” market • Deltas for calls range from 0 to +1.
conditions. When the volatility is expected to • OTM calls have deltas between 0 and +0.5.
increase, the speculative volatility traders prefer • ATM calls have delta = +0.5.
to take net-long volatility positions.
o Hedgers typically prefer to take net-long In FX markets, these delta values are quoted both in
volatility positions to hedge against absolute terms and as percentages. The most liquid
Derivatives & Risk Management Currency Management: An Introduction
Learning Module: 3

options are at-the-money options, 25-delta (delta of will be higher than the % change in premium for a
0.25), and 10-delta (delta of 0.10). 25-delta option. This implies that a very low delta
option is like a highly leveraged lottery ticket on
• The 10-delta option is deeper OTM and hence the event occurring.
cheaper than the 25-delta option. This implies that
a 10-delta strangle would be less costly and would
have a more moderate risk-reward structure than
that of a 25-delta strangle. Practice: Example 3 from the CFA
• The % change in the premium for a 5-delta option Institute’s Curriculum.
for a given % change in the spot exchange rate

9. FORWARD CONTRACTS, FX SWAPS AND CURRENCY OPTIONS

The mix of market participants on the CME is different

Various trading tools can be used for both strategic and than that of the interbank market. The CME provides
tactical risk management. These tools include: market access with tight pricing and good liquidity to
investors/traders with smaller dealing sizes and who lack
the creditworthiness in order to access the FX market
1. Forward Contracts
through other channels.

1) Forward Contracts: Futures or forward contracts on The market participants on the CME include small hedge
currencies can be used to fully hedge the currency funds, proprietary trading firms, active individual traders,
risk. Institutional investors prefer to use forward and managed futures funds (pools of private capital
contracts rather than futures contracts because managed on a discretionary basis by commodity
unlike forward contracts, trading advisors).

• Futures contracts are standardized in terms of i) Hedge Ratios with Forward Contracts
settlement dates and contract sizes and
therefore, they may not be available with desired The actual hedge ratio needs to be dynamically
maturity dates and sizes. rebalanced on a periodic basis in response to changes
• Futures contracts may not always be available in in market conditions. This hedge rebalancing involves
the desired currency pair and hence, multiple adjusting the size, number, and maturities of the forward
futures contracts would be needed to trade the currency contracts; e.g.
cross rates, increasing portfolio management
costs. • When the foreign-currency value of the underlying
• Liquid futures contracts may not be available assets increases (decreases), size of the hedge
against any currency in most second tier ratio should be increased (decreased).
emerging market currencies. • When the spot rate is expected to depreciate
• Futures contracts are subject to margin (appreciate), the hedge ratio should be > (<)
requirements* and also have daily mark-to-market 100%.
which tie up investor’s capital and may subject
him/her to daily margin calls. As a result, the
Although dynamic hedging helps to keep the actual
investor is required to do careful monitoring and hedge ratio close to the target hedge ratio, however, it
reinvestment over time, thus, increasing portfolio involves greater transaction costs compared to static
management costs. hedge. The frequency of dynamically rebalancing the
hedge depends on various idiosyncratic factors i.e.
Forward contracts have higher liquidity compared to
futures contracts for trading in large sizes. Due to their • Manager risk aversion: The higher the degree of
higher liquidity, they are predominantly used for hedging
risk aversion, the more frequently the portfolio is
purposes globally. However, currency futures contracts
rebalanced to the target hedge ratio.
can be used for smaller trading sizes and in private
• Market view or level of confidence in the currency
wealth management. forecasts: The greater the tolerance for active
trading and the greater the level of confidence in
*Some forward contracts do require collateral to be the currency forecasts, the less frequently the
posted.
portfolio is rebalanced to the target hedge ratio.
• IPS guidelines
Futures Contracts on the Chicago Mercantile Exchange
(CME):
Derivatives & Risk Management Currency Management: An Introduction
Learning Module: 3

Refer to: Executing A Hedge from the CFA • Risk neutral portfolio manager would not hedge
Institute’s Curriculum. because the net expected value of the hedge is
negative.
• Risk-averse portfolio manager would implement
the hedge because the actual depreciation of
ii) Roll Yield the base currency can be higher than the cost of
the hedge. The risk-averse market participants
The roll yield or roll return is the return derived from selling
would take an unhedged currency risk exposure
expiring futures contract and rolling into new futures
only when the interest rate differential between
contract in order to extend the currency hedge.
the high-yield currency and low-yield currency
would be wide enough.
This rolling forward will involve selling the base currency
at the then-current spot exchange rate to settle the
forward contract, and then going long another far- Level of confidence in the currency forecasts: If the
dated forward contract (reflecting FX swap transaction). currency in which investor has long exposure is expected
to appreciate and the investor has greater confidence
in the forecasts, a lower hedge ratio would be preferred.
• When the base currency is originally bought at a
higher (lower) price and then sold at a lower
Expected value to hedging = Expected gain from
(higher) price, it results in negative (positive) roll
positive roll yield on
yield.
currency hedge –
Expected gain (or loss) for
• A roll yield is negative when the futures or forward
an unhedged position
contracts curve is in contango (upward sloping).
A roll yield is positive when the futures or forward
contracts curve is in backwardation or downward Practice: Example 4 from the CFA
sloping. Institute’s Curriculum.

• The negative roll yield can be considered as the

cost of the hedge.
2. Currency Options
o A negative roll yield is equivalent to negative
carry trade i.e. borrowing (or selling) high-yield
Currency options give investors the right (not obligation)
currencies and buying (or investing in) low-yield
to buy or sell foreign exchange at a future date at a rate
currencies. A negative roll yield is opposite of
agreed on today.
trading the forward rate bias i.e. buying at
premium and selling at discount.
Unlike forward contracts, currency options do not
o A positive roll yield is equivalent to positive carry
involve opportunity costs with regard to forgoing any
trade i.e. borrowing (or selling) low-yield
upside potential from favorable currency movements.
currencies and buying (or investing in) high-yield
However, options are expensive as they require
currencies. A positive roll yield is equivalent to
payment of an up-front premium.
trading the forward rate bias i.e. buying at
discount and selling at premium.
o The hedge ratio tends to decrease when • Long exposure to the base currency in the P/B
hedging involves negative roll yield (reflecting quote can be hedged away by buying an at-the-
higher expected cost of the hedge). Opposite money put option on the P/B currency pair. This
happens in case of positive roll yield. strategy is known as “Protective put strategy”.
o Generally, the amount of currency hedging
depends on movements in forward points, i.e. • Option premium depends on two factors i.e.
when movements in forward points reduce
(increase) hedging costs, cost/benefit ratio of i. Option’s intrinsic value (spot exchange rate –
the currency hedge improves (deteriorates) and strike price of an option). At-the-money options
consequently, the amount of hedging activity are more expensive (have higher premium)
increases (decreases). than out-of-the-money options.

ii. Option’s time value. In general, the time value

The decision to hedge the currency risk would depend
of the option tends to decline as the option
on the trade-offs between
reaches its expiry.
Level of risk aversion: When the expected depreciation
of the base currency < expected roll yield (cost of The decision to hedge the currency risk using currency
hedge), then options would depend on the trade-off between market
view of potential currency gains against currency
hedging costs and the degree of risk aversion.
Derivatives & Risk Management Currency Management: An Introduction
Learning Module: 3

Practice: Example 5 from the CFA

Institute’s Curriculum.

10. CURRENCY MANAGEMENT STRATEGIES

Under all the strategies discussed below, it is assumed • Long position in a Risk reversal = Long position in a
that the manager hedges away the long exposure to Call option + Short position in a Put option.
the base currency in the P/B quote by selling the base
currency. • Short position in a Risk reversal = Long position in a
Put option + Short position in a Call option.
1. Over-/Under-Hedging Using Forward Contracts
It must be stressed that writing options is not the best
The portfolio manager can over or under hedge the strategy because the premium income earned by selling
portfolio relative to the neutral benchmark to profit from (writing) options is fixed whereas the potential losses on
market view. The hedge ratio can be increased adverse currency moves are potentially unlimited.
(decreased) if the base currency is expected to
depreciate (appreciate). 4. Put spreads

This strategy is a form of “delta-hedging” or “dynamic

This strategy involves buying an OTM put option and
hedging” with forward contracts where the manager
writing a deeper OTM put option (with the same
seeks to avoid downside moves and capture any upside
maturity) to offset or reduce the cost of the long put.
moves of the base currency.
Besides reducing the cost of the hedge, the put spread
• The graph of the hedge’s payoff function is also reduces downside protection. Therefore, this
convex in shape, with profit plotted on vertical strategy is not appropriate to use for adverse exchange
axis and spot rate on horizontal axis. rate movements.
• Convexity is a desirable characteristic in both
fixed-income and currency hedging. In addition, the put spread only reduces the cost of the
hedge, it does not fully eliminate it. In order to make the
Protective put using out-of-the-money (OTM) put spread structure zero-cost, the manager can
2.
Options change:

The cost of using options to hedge currency risk can be a) Strike prices of the options;
reduced by buying cheaper options i.e. OTM put option
(e.g. 25 or 10-delta options) rather than an ATM (at-the- b) Notional amounts of the options i.e. a manager
money) option. can write a larger notional amount for the deeper-
OTM options e.g. 1 × 2 put spread structure.
However, use of OTM options exposes the portfolio Although this structure would reduce the cost of
manager to some downside risk because they do fully hedge to zero, it adds leverage to the options
protect the portfolio from adverse currency movements. position as the number of options being sold would
be greater than the number of options being
bought.
3. Risk reversal or Collar
c) Some combination of these two measures.
The cost of buying a put option can be offset by option
premiums received by selling (writing) options. For
5. Seagull spreads
example, a portfolio manager can buy an OTM put
option to obtain downside protection and write an OTM
call option to offset the cost of put option. This strategy is a combination of original put spread
position (1:1 proportion of notional) and a covered call
By selling a call option, the manager sells some of the position. That is,
upside potential for movements in the base currency
(i.e. upside becomes limited to the strike price on the Short seagull position = Long protective put + Short deep-
OTM call option). This approach is similar to creating a OTM Call option + Short deep-OTM Put option
collar in fixed-income markets.
• Short seagull position reduces some upside
potential (due to short call position) and increases
some downside risks (due to short put position).
Derivatives & Risk Management Currency Management: An Introduction
Learning Module: 3

than vanilla options with the same strike price. They

Long seagull position = Short protective put + are more appropriate to use for active currency
Long deep-OTM Call option + Long deep-OTM management rather than as hedging tools. Typically,
Put option digital options are used by more sophisticated
speculative market participants.
• Long seagull position provides less costly downside
protection and provides the portfolio manager
7. Section Summary
with unlimited upside potential in the base
currency beyond the strike price of the OTM call
option. If the base currency is expected to appreciate,
o Strike price of the Long or Short ATM put option is implementing currency hedge would require purchase
referred to “Body”. of base currency. In this case, the core hedge structure
o Short OTM call and put or long OTM call and put will be based on some combination of a long call option
options are referred to as “Wings”. and/or a long forward contract.
• Another strategy can be a short position in a
forward contract to fully hedge the underlying • The cost of the hedge involving a long call option
currency + Overlay the hedge position with a put can be reduced by buying an OTM call option or
spread as a tactical position to profit from modest writing options to earn premiums.
depreciation of the base currency. • The hedging costs can be reduced at the
expense of either less downside protection and/or
6. Exotic options limited upside potential.

If the base currency is expected to depreciate,

Exotic options are usually used by more sophisticated
implementing currency hedge would require sale of
market participants (e.g. currency overlay managers).
base currency. In this case, the core hedge structure will
Investment funds or corporations do not typically prefer
be based on some combination of a long put option
to use exotic options because of lack of familiarity,
and/or a short forward contract.
complex structure, difficulty in valuing these instruments
for regulatory and accounting purposes, and differences
in their hedging treatments in different jurisdictions. • The cost of the hedge involving a long put option
can be reduced by buying an OTM put option or
However, exotic options help market participants writing options to earn premiums.
manage their risk exposures at a lower cost than vanilla
options. The higher the risk aversion and the weaker the level of
confidence in the currency forecasts, the higher the
The two most common types of exotic options are as hedge ratio and the lower will be the allowed discretion
follows. for active management.

a) Knock-in/out Options: The costs of hedge include:

Knock-in Option: It is a vanilla option that is created
only when the spot exchange rate approaches some • Lost upside potential
pre-specified barrier level (other than strike price). • Potentially negative roll yield
• Upfront payments of option premiums
Knock-out Option: It is a vanilla option that ceases to
exist when the spot exchange rate approaches some
pre-specified barrier level (other than strike price).
Practice: Example 6 from the CFA
Institute’s Curriculum.
• The knock-in and knock-out options are less costly
than vanilla options because they are more
restrictive than vanilla options.
• These options provide less upside potential and/or
downside protection.

b) Digital Options: Digital options are also known as

“Binary options” or “All-or-nothing options”. Digital
options pay a fixed amount if they touch their
exercise level at any time before expiry. These options
have large payoffs and provide highly leveraged
exposures to movements in the spot rate (like lottery
ticket) and therefore, they tend to be more costly
Derivatives & Risk Management Currency Management: An Introduction
Learning Module: 3

11. HEDGING MULTIPLE FOREIGN CURRENCIES

Hedging multiple foreign currencies uses the same tools

and strategies used in hedging a single foreign currency
2. Minimum-Variance Hedge Ratio
exposure.

However, for hedging multiple foreign currencies Change in the value of the asset to be hedged = α
exposures, the correlation between residual currency +[Optimal hedging ratio × Change in value of the
exposures on the portfolio should be considered. hedging instrument] + ε

Optimal hedging ratio or the Beta coefficient in the

1. Cross Hedges and Macro Hedges
above regression represents the sensitivity of the
domestic-currency return on the portfolio to % change in
A cross hedge refers to hedging long foreign currency the spot rate.
exposure in one currency by taking short position in a
positively correlated currency. Essentially, cross hedge In simple terms,
efghijk ljkmn fo pqn rnshljphlnt ufipsjup mtnr jt j qnrvn
transfers the currency risk from one foreign currency to Hedge ratio =
wjsxnp ljkmn fo pqn qnrvnr jttnp
another foreign currency.
The hedge ratio that minimizes the variance of ε and the
When a portfolio has negatively correlated residual
tracking error between changes in the value of the
currency exposures (i.e. long currency A/short-currency
hedge and changes in the value of the hedged asset is
B that is closely correlated to currency A), then the
referred to as “Optimal Hedging Ratio”.
portfolio is said to have a “natural” cross hedge. A
natural cross hedge position helps to reduce the
Minimum or Optimal hedge ratio =
portfolio risk without using a direct hedge on the
currency exposure.
! Standard Deviation (RDC ) $
Correlation (RDC; RFX) × # &
Though terms Proxy hedge and Cross hedge are " Standard Deviation (RFX ) %
used interchangeably. However, a clear distinction
between proxy and cross hedge is given below:
• The minimum-variance hedge ratio can be quite
• Proxy hedge: eliminates FC (foreign currency) risk different from 100% when:
by hedging it to the investor’ home currency.
o The hedge is jointly optimized over both
• Cross Hedge: Moves currency risk from one FC to exchange rate movements RFX foreign-currency
another FC. value of the asset RFC.
o There is a lack of liquid forward contracts for a
specific currency pair.
Macro Hedge: A macro hedge is a type of cross hedge o Macro hedges are implemented.
in which a portfolio is viewed as a collection of risk
exposures (i.e. term risk, credit risk, and liquidity risk or • Minimum-variance hedge ratios are typically
other risk exposures e.g. recession, financial sector stress calculated only for “indirect” hedges based on
or inflation). The portfolio can be hedged against cross hedging or macro hedges. They are not
extreme market events by calculated for “direct” hedges because the
correlation between movements in the spot rate
• Investing in gold; and its forward contract tends to be close to +1
• Using volatility overlay program; and the variance in spot price movements tends
• Using a derivative product based on an index to be approximately equal to the variance in the
(typically a fixed-weight baskets of currencies), price of the forward contract.
rather than specific assets or currencies;
• It must be stressed that since optimal hedge ratios
are calculated using historical data, therefore,
A macro hedge using currency basket derivatives is
they may not be representative of future changes
appropriate to use for hedging currency risk in a multi-
in prices.
currency portfolio.

3. Basis Risk
Practice: Example 7 from the CFA
Institute’s Curriculum. When the price movements in the asset being hedged
are not perfectly correlated with the price movements in
the cross-hedge or macro-hedge instrument and when
Derivatives & Risk Management Currency Management: An Introduction
Learning Module: 3

the correlation is not constant (i.e. changes with time), it over both exchange rate movements RFX and
is referred to as “Basis Risk”. changes in the foreign-currency value of the asset
RFC using a single-variable OLS regression
For a minimum-variance hedge ratio, basis risk implies technique.
instability in the β coefficient estimate i.e. the minimum-
variance hedge ratios need to be re-estimated as more • The optimal hedge ratio based jointly on
data becomes available. movements in RFC and RFX for international bond
portfolios is almost always close to 100%.
• To avoid basis risk, all cross hedges and macro
hedges should be monitored and rebalanced • The optimal hedge ratio for single-country foreign
periodically to account for changes in equity portfolios varies widely from 100% between
correlations. currencies, and tends to depend on both the
investor’s domestic currency and the currency of
Optimal Minimum-Variance Hedges the foreign investment. The optimal hedge ratio
also depends on market conditions and longer-
term trends in currency pairs.
• For a simple foreign-currency asset portfolio, the
variance of the all-in domestic currency return
can be reduced by jointly optimizing the hedge

12. CURRENCY MANAGEMENT TOOLS AND STRATEGIES

There is no single or “best” way to hedge currency risk.

At the strategic level, currency strategy will depend on The portfolio manager must perform a due diligence
guidelines for risk exposures, permissible hedging tools, analysis of potential hedging tools/strategies and must
and strategies set by the IPS. make a rational decision on a cost/benefit basis.

At tactical level, currency strategy will depend on the

manager’s management style, market view, risk
Practice: Example 8 from the CFA
tolerance and manager’s perceptions of the relative
costs and benefits of any given strategy. Institute’s Curriculum.

CURRENCY MANAGEMENT FOR

13.
EMERGING MARKET CURRENCIES

Special Considerations in Managing Emerging depend on normal distributions understate the

1.
Market Currency Exposures portfolio’s risk and are therefore not appropriate to
use for emerging market currencies exposures.
1) Many emerging market currencies are thinly traded
and thus, involve higher trading costs (bid-offer Factors affecting currency management include:
spreads) than the major currencies under “normal” Currency crisis and extreme price movements in
market conditions. financial markets can undermine the utility of hedging
strategies based on forward contracts and options
• Due to lack of exchange-traded derivative because currency crisis affects both the volatility in asset
products in emerging markets, investors have to prices and their correlations, through “contagion”
use OTC derivatives with relatively high mark-ups. effects.
These high mark-ups increase trading and
hedging costs. Government involvement in setting the exchange rate,
using measures i.e. foreign exchange market
2) Emerging markets tend to have a higher probability of intervention, capital controls, and pegged (or at least
extreme market events and thus, emerging market tightly managed) exchange rates, can lead to sharp
currencies suffer from severe illiquidity under stressed movements in prices.
market conditions.
E.g. a central bank may increase the policy rate to
This implies that return distributions for emerging support the domestic currency when it is under severe
market currencies are negatively skewed. Hence, risk downward pressure. Due to higher interest rates, the
measurement and control tools (i.e. VAR) that
Derivatives & Risk Management Currency Management: An Introduction
Learning Module: 3

forward discount for that currency increases, leading to

negative roll yield. • However, NDFs may suffer from market risk (tail
risk) as the abrupt changes in government policy
2. Non-Deliverable Forwards associated with government involvement in the
foreign exchange markets may lead to extreme
movements in spot and NDF rates.
Non-deliverable forwards (NDFs) are forward contracts in
which the controlled currency is neither delivered nor
received. NDFs are cash settled and the settlement is in NOTE:
non-controlled currency.
The retail version of a NDF contract is known as a
The non-controlled currency for NDFs is usually the USD or “Contract for differences” (CFD) and is available at
some other major currency. NDFs are typically used for various retail FX brokers.
currencies which are subject to capital controls e.g.
Chinese Yuan, Korean Won, and Russian Ruble etc. Practice: CFA Institute’s end of
Chapter Practice Problems for this
• In general, NDFs have lower credit risk than that of Learning Module and FinQuiz
the outright “vanilla” forward because unlike an Questions + Item-sets.
outright “vanilla” forward contract, the principal
sums in the NDF remain constant.