Currency Overlay Techniques and Perspectives - Essay Example

Running head: CURRENCY OVERLAY AND INTERNATIONAL DIVERSIFICATION Currency Overlay Techniques and Perspectives on International Portfolio Diversification Student Name School Name Abstract For the past several decades, a well-constructed portfolio management model has included as part of its risk reduction methodology the designation of a significant percentage of the portfolio holdings to be in foreign equities, specifically those from Europe, Asia, and the Far East. Likewise, sophisticated currency hedging methods have been developed as another portfolio protection device. One set of three articles by professionals with educated but differing views on the rationale of international diversification will be compared and contrasted. A second set of three articles by equally educated financial experts on the techniques of currency hedging, with some necessary simplification, will be critically evaluated. Both analyses bring a fresh perspective and respectfully questioning attitude to traditional portfolio management models. Q1: Critically Evaluate the Techniques of Creating Currency Overlays What are the advantages and disadvantages, or more specifically, the risks and rewards, of several common currency overlay schemes? In “Mean/Variance Analysis of Currency Overlays” by Philippe Jorion, three of the four most common strategies are discussed and analyzed. These are 1) joint, or unit, currency management, its goal to optimize or hedge the entirety of the underlying assets, be they stocks, bonds, or currencies themselves; 2) partial optimization over the currencies, given a pre-determined position in the core portfolio; and 3) a separate optimization over currencies. In unit or joint hedging, it is assumed that “the manager has expertise in many asset classes and can structure a portfolio to account for correlations between assets and currencies,” (Jorion, 1994). Partial optimization manages currencies “separately from the core portfolio, but the manager still controls total portfolio risk.” Employing the method of separate optimization means to manage the currencies “completely independently of the rest of the portfolio,” even going so far as to measure their performance against a separate benchmark or hire a separate currency overlay manager to deal with this part of the portfolio as opposed to the equity manager. In the unit hedging approach, the tools work together to maximize the performance in light of the unique composition of the portfolio. Clearly, if done properly, this is the optimal approach. Partial optimization has the advantage of looking at the risk of the portfolio as a total, but manages the currencies separately from the core portfolio. It is hard to see how hedged returns could be equivalent on average using an approach that is indifferent to the core equity holdings. The separate optimization approach appears on the one hand to have the advantage of hiring an expert in currency overlays, because it’s common sense that not all portfolio managers can be experts in all aspects of portfolio management. Empirical evidence indicates that “unhedged stock returns appear to be positively correlated with exchange rates…therefore optimizing currencies and underlying unhedged assets separately cannot be optimal” (Jorion, 1994). “Cleary, going from [unit hedging] to [separate optimization] is successively less optimal.” The mean/variance approach to hedging is the closet thing to a “free lunch” since it “provides a unified framework for evaluating different approaches to currency management” (Jorion). Such unitary or “full” currency hedging offers “reduced risk with no commensurate reduction in returns.” However, the fact that “currency positions are kept constant throughout the sample period…may understate the benefits from currency management if active managers systematically outperform their benchmarks.” We know, however, that the latter is rarely the case. It is intuitively true that there would be no risk premium in currency hedging, since “forward contracts are in net zero supply” and “because any gains must be offset by losses to the counterparty” (Jorion). However, this may not be completely accurate; stock index futures are also in net zero supply, but because “they are linked to the underlying stocks…when held to maturity, a long position in futures is equivalent to a long position in the underlying cash instruments.” Kritzman discusses the importance of hedging in “The Minimum-Risk Currency Hedge Ratio and Foreign Asset Exposure,” but essentially concludes that despite the increased interest in protection from currency risk, especially “in light of the confusion in the European currency markets,” we are far from reaching a consensus about the optimal hedging policy. He quotes Black, who argues that, “in equilibrium, investors should hedge the same percentage of currency exposure regardless of the underlying portfolio,” an approach that seemed suboptimal according to Jorion, while others, according to Kritzman, argue that “hedging is only relevant when a large fraction of the portfolio is allocated to foreign assets,” a position with which Jorion might also agree. Kritzman discusses hedging from a beta-based position in his article, “What Practitioners Need to Know About Hedging.” This approach has a mathematical appeal because it approaches the issue from a purely objective perspective. Rather than “selling currency forward or futures contracts in an amount equal to the currency exposure of our investments…we are more likely to reduce currency risk if we condition the amount we hedge on the beta of our portfolio with respect to the relevant currency.” The straightforward formula employed is given by Kritzman below:  = p x p /c where  = the portfolio beta with respect to currency, p = correlation between the portfolio and the subject currency, p = the standard deviation of the portfolio, and c = the standard deviation of the subject currency. The portfolio risk minimization effect of a beta-derived currency hedge strategy can be verified “by computing the standard deviation of a portfolio combined with a short position in a currency forward contract,” (Kritzman). This is shown as follows: p + F = (2p + 2r x W2 + 2 x p x p x x r x W)1/2 Where p + F = the standard deviation of the combination of the portfolio and forward contract, p = the standard deviation of the underlying portfolio, f = the standard deviation of the currency forward contract, W = the weighting of the currency forward contract, and p = the correlation of the underlying portfolio and currency forward contract. There is cost associated with hedging activities, however approached. Ultimately, how much time, effort, and expense to devote to it is the sponsor’s call. Q2: Compare and Contrast Positions on International Portfolio Diversification “Where Are the Gains from International Diversification?” The thesis of this article by R. A. Sinquefield is that international value stocks and international small stocks diversify U.S. portfolios more the EAFE. Though sponsors as well as academics continue to propagate the traditional position that foreign equities should outperform U.S. equities, “there is no empirical evidence that major international-marketlike (sic) portfolios reliably outperform the U.S. market” (Sinquefield, 1996). Even though EAFE outperformed the S&P 500 between 1970 and 1994, this was due to foreign currencies outperforming the dollar (Sinquefield). In “Why Not Diversify Internationally Rather Than Domestically?” Bruno Solnik asserts, “Substantial advantages in risk reduction can be attained through portfolio diversification in foreign securities.” Two selection methods for diversification are across geographical areas and across industries (the latter being, according to Solnik, “the more conventional method”). However, he finds that diversification across countries lowers portfolio risk more than diversification across industries. In his models, he included the effect of currency hedging; so the difference in portfolio performance found by Sinquefield and Solnik is likely to be much lower, despite the extent to which their positions on the importance of international diversification initially appear to differ. Despite the obvious risk of currency fluctuations, sponsors widely hold to the belief that the variance of foreign equities and their correlation with the United States are low enough to make them effective risk reducers for U.S. portfolios, but Sinquefield found “their variances and correlations with the United States are too high to make them good risk reducers.” As he stated above, because international value and international small stocks diversify U.S. portfolios more than EAFE, “If one does not wish to concentrate in such stocks…international diversification for U.S. sponsors may be unnecessary.” Solnik brings up an interesting point regarding international diversification motivations for U.S. sponsors versus European sponsors by bringing out the fact that the U.S. proportion of private corporations is much lower than in Europe. In Germany, for example, “only 44 percent of the typical risk of individual securities can be diversified away” compared to the U.S., where the non-diversifiable risk is only 27 percent (Solnik, 1995). This makes international diversification not only more attractive to the European sponsor, but one could say an absolute necessity. European sponsors still face the same requirement to minimize currency risk when diversifying internationally. It hardly needs to be reiterated that “the risk of a portfolio unprotected against exchange risk is larger than for a covered portfolio,” except to note that the total risk of an uncovered internationally diversified portfolio is still less than the risk of a comparable domestic portfolio (Solnik, 1995). Though not explicitly stated, a reasonable inference is that the “comparable domestic portfolio” to which Solnik refers here is a U. S. portfolio. Burik and Ennis enter the diversification discussion by examining the question of whether non-dollar bonds belong in diversified portfolios in their article, “Foreign Bonds in Diversified Portfolios: A Limited Advantage.” They point out that “unhedged foreign bond portfolios embody a substantial component of currency risk” (Burik and Ennis, 1990). However, unlike other methods of addressing currency risk, characteristics unique to foreign bonds make their benefits ultimately negligible, especially when the added expense of management and custody fees are considered. Further, “U.S. investors in foreign bonds may be subject to withholding taxes that in some cases are non-refundable” (Burik and Ennis). They also point out that there are important differences in the U.S. versus the foreign bond market: “Most foreign markets are dominated by government issues to a greater extent than the U.S. market is” and “there are also important differences in the liquidity and quality” between the two. All three articles mention the difference between the performance of a passively and “superior” actively managed portfolio, (Burik and Ennis, 1990), as well as the expected return and risk of portfolios of widely differing sizes. Burik and Ennis’ conclusion is that smaller, less actively managed portfolios should pass on foreign bonds altogether because “the expected return, or premium, associated with the foreign exchange component of foreign bonds does not differ appreciably from zero.” Foreign currency hedging by any method, “is (for now) a complex and imperfect science” (Burik and Ennis), though still necessary. According to Solnik, “If…an investor in foreign securities does not protect himself against exchange rate fluctuations, he is in fact speculating on currencies.” That is quite a different pursuit than diversifying a portfolio in order to reduce its overall risk. References Burik, P., & Ennis, R. (Mar/Apr 1990). Foreign bonds in diversified portfolios: a limited advantage. Financial Analysts Journal, 31-40. Jorion, P. (May/Jun 1994). Mean/variance analysis of currency overlays. Financial Analysts Journal, 48-56. Kritzman, M. (Sep/Oct 1993). What practitioners need to know about hedging. Financial Analysts Journal, 22-26. Kritzman, M. (Sep/Oct 1993). The minimum risk currency hedge ratio and foreign asset exposure. Financial Analysts Journal,77-78. Sinquefield, R. A. ( Jan/Feb1996). Where are the gains from international diversification?. Financial Analysts Journal, 8-14. Solnik, B. (Jan/Feb1995). Why not diversify internationally rather than domestically? Financial Analysts Journal, 89-94. Read More