The International Guide of Foreign Currency Managementby Shoup - Research Paper Example

?Literature Review Currency has been defined by Shoup (1998) in “The International Guide of Foreign Currency Management”, as a medium of exchange forthe supply of goods recognizable by the state and has the legal support of the State’s Authority. In essence the value and the amount of currency available to the population is regulated by the ability of the government to finance its debt and other financial instruments. (Goldstein, 1992) Currency and its management determine the economical footing of the State and as such must be strictly controlled by the Government. Strength and value of a States currency is affected by several contributing factors. These factors may be intentionally implemented or developed as a result of external impact. This was seen in South Africa in the 1980’s when the price of Gold had significantly fallen in addition to other financial challenges faced by the government during the same period. As a result what was seen in South Africa was a drastic devaluation of the Rand in comparison to the American dollar. (Murison 2003) South Africa never fully recovered from the devaluation of the Country’s currency. Currency management operates on three basic tenets according to JP Morgan’s “Active Currency Management for Institutional Investors”. These are; market dynamics which refer to the foreign exchange market where it is inefficient and offers potential alpha due to the high proportion of non-profit seeking participants. Secondly there is consistent return which requires active currency managers who are able to generate consistent and modest returns throughout the market cycles. Finally there is diversification which refers to the returns of active currency managers who are not highly correlated with traditional asset classes. JP Morgan in Passive Currency Management (2011) identifies three ideal steps at the strategic level for passive currency management. Firstly, there is the need for the modelling of the foreign currency plan based on the risks identified in each business and determining a hedge ratio for the sensitive areas. Secondly, there is the need to cover the exposures of the assets through the use of various hedging techniques that are appropriate in the situation. Thirdly, there is the need to execute and monitor the plan with regards to transaction costs. JP Morgan emphasised that the most popular hedging technique for passive currency management is the use of forward currency contracts. Fabozzi (2008) assesses passive currency management techniques and identifies three main elements of this currency risk management approach. First of all, the management takes a standard currency hedging and roll it over through the life of an investment. Secondly, it is not flexible and cannot be changed even if external conditions change. Thirdly passive currency risk management involves the continuous conversion of the home currency to a given currency on a frequent basis. Currency risk exposure was later categorized into three groups by Zubulake, 1991who sought to determine preventative measures. These are; the translation which refers to the uncertainty of converting foreign denominated assets to local currency. Where there is uncertainty on the foreign market then the stability of the currency is threatened since sectors such as banking and real estate remains stagnated. The second category of risk exposure is that of transactional risk which detail the effects of fluctuations in exchange rates on revenues, expenses and profitability. Risky transactions have the potential to restrict the spending and trading ability of the population. Spending and trading being two of the main means of currency circulation will significantly impact on the Country’s economy when restricted. Thirdly, there is the economic exposure currency risks which assess the effects of fluctuations in a Country's currency over the long-term macro economics of the country, namely, prices, competition and export. As such, measures must be implemented to ensure that where there is exposure the effects are not lasting. With the possible risks highlighted, there have been measures developed by economists to cushion the effects of exposure. These include the technique of hedging and other currency risk management techniques. Implementations of these techniques help to reduce the effects to corporate entities enabling them to compete with other entities from other economies. Hedging is one technique which is used to negative the effects of adverse price movements in assets, Hicks in his article “Managing Currency Risk Using Forex Options” highlights that financial future of foreign currency which is agreed upon is also a means of effective hedging. Hedging currency is a risky process depending on how the principles are applied, such as where there is “exchange of a unit of the base currency for a variable number of units of term currency” outlined by Agar 2011. This has been a practice introduced by Solnik, Adler and Dumas and Black where investors do not rely on the economy exchange but rather trade using their own currency as numeraire. There are varying means of hedging these have been highlighted by Levrich, Richard M. et al. in “The Merits of Active Currency Risk Management: Evidence from International Bond Portfolio”. There is popular debate in academia and in practice whether it is necessary to hedge foreign currency risk at all or not (Financial Analyst, 2010). This perception has been settled after the Finacnial Analyst’s study which indicates a 100% conviction that it is necessary for a business to hedge. This confirms Levrich’s findings that if these techniques are applied then currency problems may be quickly converted into active currency management. In the 1993 article, Levrich states that a partial and selective hedging may be more effective resulting in superior results than if the investors were practicing full hedging or no hedging. Hedging maybe passive or active hedging, “Passive currency hedging or [passive] currency management involves the creation of a currency hedging benchmark and sticking to that benchmark” (Henderson, 2006: 166). In practice, this is often done by identifying a bottom line of financial assets that will be hedged and coming up with a strategy to hedge it. This is usually in the form of a strategic level decision which is taken by top-level management of a corporate entity. Hedging may however be used as a financial future which is created where the price of a foreign currency is agreed on now but the delivery of the financial instrument is on a date in the future (Hicks, 2009). This is one of the most prominent techniques incorporated in the strategy of corporate entities to reduce the economical risk. In most corporate entities, hedging is used tactically and strategically by the corporate treasury to manage currency risks (Henderson, 2006). Transactional currency risks are hedged using models designed by the treasury on a corporate level (Henderson, 2006). Translational risks are hedged opportunistically on a case-by-case basis which is evaluated on the basis of the peculiar circumstances surrounding major and occasional currency transactions. Perold & Schulman (1988) argue strongly that hedging is important because it enables a business to consolidate its hold on foreign currency risks. This enables a business to control the interest risks in the short run however the effectiveness of 100% hedging diminishes over longer time horizons. This makes it more appropriate for fixed income funds and they would therefore need to frequently adapt foreign currency benchmarks for hedging. To the contrary, Froot (1993) argued that hedging is not necessary to control foreign currency risks. This is because desisting from hedging leads to optimal results for investors with longer term horizons. This is because these funds are not susceptible to short term transfers therefore these funds are not affected by changes in the local currency where there are no transfers in the short-term. Where it is a passive approach taken to hedging there are several disadvantages as passive currency risk management comes with serious inherent issues. First, setting the standard for currency hedging can come with enormous issues. There might not be an identification of the best options available on the market and thus take a step that might lead to more foreign exchange losses than gains. A practical example is in the case of the South African Rand which has appreciated in value and enjoyed a relatively stronger status than the US Dollars in the past year. Secondly, passive currency risk management is inflexible. In that, when there are positive changes in the external environment, the benchmark cannot be changed to benefit from the changes. In other words, where there are unexpected benefits from external factors, the hedging arrangements initially made cannot be changed. This rigidity though might has its benefits may also be a disadvantageous tool. This leads to the issue of opportunity costs which is the relative investment returns forgone if the rigidly hedged funds were used for other ventures that would bring higher returns. (Fabozzi, 2008) Fabozzi continue to explain a third factor of passive currency hedging which is a continuous process and it requires frequent transactions at higher costs. If these transaction costs are considered in the calculation of the worth of these risk management, the total cost of a passive currency risk management regime will be severely increased thereby making its cost-effectiveness questionable. Fabozzi’s concerns will therefore be addressed by applying Levrich’s principles which recommends that there may be the use of partial hedging to result in an active currency management. Another technique which has been identified for economic risks which according to Henderson, 2006:142 economic risks “...are managed by forecasting revenue streams over a given period of time and analysing the potential impacts on exchange rate deviations from rates used in calculating costs and revenues”, is that of the Value at Risk Model. Economic risks come with various complications related to forecasting and planning. Such risks management drive demands the use of the value at risk model (VaR) which is “the maximum loss for a given exposure over a given time horizon with a specified degree of confidence” (Henderson, 2006: 143). Value at risk is a method used to analyse the highest amounts an investor can lose on a given investment portfolio (New York University, 2009). This method seeks to use various techniques to identify with certainty the maximum amount of money an investor can lose at a given time. It measures the potential loss in value of a risk asset or portfolio over a given confidence interval. Thus if an asset is R1million at a week and has a 95% confidence level, there is a 5% chance that it will drop below R1million over the week (New York University, 2009). Value at Risk (VaR) is often calculated using the Monte Carlo method. The method is used in a 5-stage process as outlined below (Best, 2006). Firstly, the risk manager has to identify the volatilities and the correlation of the risk factors. Secondly, there must be a generation of nominal price scenarios with correct volatilities. The next step is the calculation of the eigenvalues and eigenvectors for the condition of the metrics. Fourthly there must be a generation of the correlated price scenarios. The final step is to generate portfolio changes and rank them as per historical simulations. In corporate entities, the normal way of controlling foreign currency risk is the establishment of a central exchange facility to device companywide strategies (Hough et al, 2003). This unit will often be tasked with the formation of various units to be in charge of the three main forms of foreign currency risks: transactional, translational and economic. They will have to employ forecasting techniques to scan the environment regularly. Also, there should be reporting systems and structures to ensure that foreign exchange reports are periodically submitted and examined. The third technique which has been identified as suitable to control the currency value is that of Active Currency Management which aims at bringing in more returns whilst lowering transaction costs. The logic behind the success of active currency management is that it involves currency returns through currency investments which means borrowing (going short) in one currency and lend (going long) in another currency (Martini, 2007). It is clear that we pay interest rate on what we borrow and earn interest on what we lend. This therefore means that active currency management utilises the interest rate differentials and exchange rate changes (Martini, 2007). This is done by analysing the efficient market status at any given point in time and having in-depth knowledge of the realities on the market at each point in time. JP Morgan emphasised that the investment of funds are linked to currency exposure through a strategic decision to diversify and invest comprehensively and avoid overvalued currencies. The investor identifies the most competitively priced goods and scenarios as well as capital assets with high rates of returns. This is done by speculating and investing in places where currencies earn higher interest rates and the currency market trends observed over a long period of time look favourable. JP Morgan (2011) state that Active Currency Management is basically linked to the investment of funds that are linked to currency exposure through a strategic decision to diversify and invest comprehensively and avoid overvalued currencies. The investor identifies the most competitively priced goods and scenarios as well as capital assets with high rates of returns. This is done by speculating and investing in places where currencies earn higher interest rates and the currency market trends observed over a long period of time look favourable. There are three main forms of active currency management (Rajkumar & Dorfman, 2010) which are pure alpha, outlay hedging and hedging of both home and foreign currency. Rajkumar & Dorfman describe the three forms of active currency hedging as follows: 1. Pure alpha generates returns by creating new currency risk in that active positions are identified globally. When this is done, funds are traded in these positions with the view of beating the currency risk and generating some returns to offset the shortfalls in the value of the currency when it is converted to the base currency. 2. Overlay hedging involves hedging an existing fund’s foreign currency risk. Here the active positions are tied to foreign currency exposure and foreign currency risk is managed only against the home currency to ensure that changes in the value of the home currency do not affect the worth of the existing fund. 3. Hedging of home and foreign currency involves generating returns by an appropriate mix of home and foreign currency risks. Active positions are different from each other and both foreign and home currencies are trained to manage the existing risk. The strength of this form of active currency risk management is that it spreads the risk of both currencies fairly thereby neutralising any currency falls. Steward & Lynch defines active currency management as a form of portfolio management which manages currency and interest rate risks. It handles currency exposures through the diversification of these risks by investing in a wide variety of options on the local and international market to balance off the risk. They went on to outline the following steps in active currency risk management. First, investment objectives must be established, followed by the guidelines which regulate the investment from within the organisation. Thirdly, there is the need to develop a portfolio strategy which will be the best strategy for the completion of the investment. And finally, there is the need to construct the portfolio, monitor risks and evaluate performance. Fabozzi outlines that to give sufficient currency risk coverage the ideal process for active currency risk management starts from the definition of currency risks and spreading the risks between top and bottom performing bond markets. He recommends that the average return in local market terms should be 13% and when spread, it should add up to a total of 28%. In spite of the higher returns promised by active currency management, research has shown that it is only 5% of foreign currency transactions which may be classified as active currency management drives. Active Currency Management drives are meant to generate extra revenue by capitalizing on the differences in foreign currencies (Ebbage, 2008). 95% of foreign currency risk management transactions are conducted for functional reasons like import and export and other hedging drives meant to protect assets from adverse currency movements in the traditional passive fashion (Ebbage). This therefore means that there is more potential in the Active Currency Management market for international organisations including those trading in South Africa. Ebbage, attributes this to the traditional assumption that once a business trades in a given country, that country has a good currency and thus ordinary hedging is good enough. Most businesses attitude towards hedging is a passive approach this is done by use of in-house staff who handles the treasury to set the ratios using the traditional approach. As stated earlier less is achieved from a passive approach and therefore active currency trading works best if one uses an outsourced portfolio manager who is equipped to trade skilfully. This is because active currency management demands a lot of expert knowledge about the markets within which the foreign currency is managed as well as in-depth knowledge about finance and forecasting techniques and principles. JP Morgan identifies six important factors that must be taken into consideration when using Active Currency Risk Management. There is the need for diversification where one does not have to invest foreign currency funds in a single venture, but rather, it is best to spread the risks over a given portfolio of assets. Secondly, there is the need for the use of factual and comprehensive processes and tools for the analyses of the options available. Thirdly, there is the need to avoid overvalued currencies in favour of cheap currencies (this is common among richer nations with huge foreign currency reserves). Fourthly, there is the need to buy currencies with high real and nominal rates of interest and sell those with low ones. Fifthly, there is the need to buy currencies in capital markets that are performing relatively strongly. Finally, there is the need to buy currencies that are trending upwards and avoid those that are declining. Like hedging there is passive currency management Fabozzi (2008) assesses passive currency management techniques and identifies three main elements of this currency risk management approach. First of all, the management takes a standard currency hedging and roll it over through the life of an investment. Secondly, it is not flexible and cannot be changed even if external conditions change. Thirdly passive currency risk management involves the continuous conversion of the home currency to a given currency on a frequent basis. Passive currency management entails having a currency risk management policy for part of your financial systems (Rajkumar & Dorfman, 2010). In this case, there is a ratio of foreign currency that is hedged to control foreign currency risks. There is the need for strong systems and tools together with a good policy to ensure that the corporate treasury of South African based companies can make use of active currency management. A strong system is one that will make and equip the treasury of a corporate entity with the competencies for the analysis of the efficient market status and realities of the potential markets. This can be done by having updated and regular information about five main issues in potential markets at various points in time these are according to Martini, (2007): 1. Currency probabilities on the markets: This entails the actual probabilities of events and activities that will affect currencies in different markets around the world. These probabilities must be as accurate as possible and they should reflect the realities in the economy under review and also be able to give some degree of certainty for the purpose of forecasting. 2. Interest Rate Differentials: There should be information about interest rates in a given economy which is reliable and can be used to assist in decision making. Like currency probabilities, there should be forecasting tools and models that can be used to analyse short-term and long term events to help in predicting changes in the future for appropriate actions to be taken. 3. Current account of trends in the economy: There should be a system to identify the relative current account-to-GDP ratios which is an important component of activities like external debt dynamics that will affect exchange rate movements in the long run. 4. Purchasing power parity: The deviations between purchasing power parity and the market's purchasing power parity in exchange rates reflect domestic pricing imbalances and it can trigger exchange rate movements in the long run. 5. Momentum (Trends): This should also be available for the Active Currency Management team to get an idea of how things are and how things will continue into the future. Through trends, the active currency management team can always make predictions that are likely to be accurate and closer to the actual. System must be supported by tools which are capable of effectively producing the desired results as such JP Morgan (2011) outlined five tools which may be used to achieve the desired results. These are recommended as supporting tools in achieving a effective active currency management. The five major tools and techniques that must be available to utilise the information gathered about the relevant subjects include: 1. Risk Management: This is a major tool that will enable the corporate treasury to appraise and analyse the internal structures of the organisation and how they are affected by the foreign currency risks. Without knowledge and mastery of these techniques, there is little chance that an active currency management strategy will ever work in an organisation. 2. Compliance: There is the need for an understanding of the various compliance requirements from within South Africa and also in the countries where the currency funds will be invested. 3. Trends: Trend analysis is an important technique for understanding and building sufficient knowledge of the potential markets. This tool is indispensable for a successful treasury team in an active currency management effort. 4. Technology: A good corporate treasury must have the appropriate technology for the collection of information and the analyses of such information and data. This means that a good treasury must have the most efficient and effective software, hardware and database for the collection of timely information and analyses and interpretation of such information. 5. Investment Risks: For a corporate treasury to succeed, it will need to have a strong understanding of specific and general investment risks that are involved in each possible strategy. It is only through this that they can select the best investment programmes to partake in. Fabiozzi, (2007) outlines that there is the need for the top-level management of the organisation to put in place a good mechanism. This fuses any active foreign currency management project in the overall strategy of the organisation. Corporate clients can do this by identifying the various variables and modifying them to suit the best needs of the company. In doing this the main variables will depend on: 1. The investment objectives that suits the business in the South African economy. 2. Specified rules for attaining those objectives set by managers of the foreign currency fund. 3. The evaluation and selection of the best strategy for the investment. 4. Selection of the range of portfolios and how to blend these portfolios. 5. How to monitor the investment. This should be done with the view of rescaling the currency hedge to match any movements in the underlying securities' portfolio. To ensure that the most suitable approach is used and the appropriate decision made in trading then emphasis must be place on the selection of personnel. Fabozzi (2008) identifies that the portfolio manager identifies favourable patterns over long periods of time enabling the entity to benefit from random and artificial elements of currency exchange, and/or fluctuations deliberately created by Central Banks. In the case of the South African Reserve Bank, the IMF reports that it eliminated its negative net open forward exchange position in May 2003 (IMF, 2006), this means that the bank removed external vulnerabilities and accumulated additional gross reserves and this can lead to various degrees of 'artificial' foreign currency opportunities which can be utilised by the treasuries of various companies in the country. This gives an example of the various situations that can lead to foreign currency advantages. The investigation of the researches have therefore outlined that though there are several factors which affects the currency of a Country there are several measures which corporate clients may use to steer the economy in the direction desired. References 1. Agar, Christopher (2011) Capital Investment & Financing: A Practical Guide to Financial Evaluation Butterworth-Heinemann 2. Beauchense, Eric (2009) “Take the Risk Out of Currency Hedging” Exportwise Fall 2009. 3. Best, Philip (2006) Implementing Value at Risk 3Edn Hoboken, NJ: John Wiley & Sons 4. Collier, Paul M. & Agyei-Ampomah, Samuel (2006) CIMA Official Learning System: Management Accounting Risk & Control Strategy London: Butterworth-Heinemann. 5. Correia, Carlos; Flynn, David; Viliana Enrico; Wormald Michael (2007) Financial Management 8 Edn Juta & Co: Cape Town 6. Ebbage, Alison (2008) “The Case for Active Currency Management” in FT Mandate Available online at: http://www.ftmandate.com/news/fullstory.php/aid/1882/The_case_for_active_currency_management.html Accessed: 24th June, 2011 7. Fabozzi, Frank J. (2007) Fixed Income Analysis Hoboken, NJ: John Wiley & Sons 8. Fabozzi, Frank J. (2008) Perspectives on Investment Management of Public Pension Funds New Hope, PA: Frank J Fabozzi & Associates 9. Financial Analyst (2010) To Hedge or Not to Hedge: That is the Question. Available online at: http://www.financial-analyst.info/to-hedge-or-not-to-hedge-%E2%80%94-that-is-the-question/ Accessed: 5th July, 2011 10. Forex Blog (2010) South African Rand Against US Dollar Available online at: http://www.forexblog.org/wp-content/uploads/2010/01/Rand-Dollar-2009-2010.png Accessed: 5th July, 2011 11. Froot, Kenneth (1993) “Currency Hedging over Long Horizons” National Bureau of Economic Research Inc. Working Paper Number 435. 12. 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JP Morgan – Active Currency Management (2011) Active Currency Management Available at: http://www.jpmorgan.com/pages/jpmorgan/am/ia/investment_strategies/currency/active Accessed 24th June, 2011 20. JP Morgan – Passive Currency Management (2011) Passive Currency Management Available online at: http://www.jpmorgan.com/pages/jpmorgan/am/ia/investment_strategies/currency/passive Accessed 24th June, 2011 21. JP Morgan – Active Currency Management (2009) Active Currency Management Institutional Investors Available at: www.jpmorgan.com/tss/General/Active_Currency_Management_for_Institutional_Investors/1159398587926 Accessed 6th July 2011 22. Koller, Tim (2010) Valuation: Measuring & Managing The Value of Companies John Wiley & Sons 23. 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Risk Limited Corporation (2010) Delta Hedging: Theory and Application Available online at: http://www.risklimited.com/Delta-Hedging.pdf Accessed 20th June, 2011 30. Shoup, Gary (1998) The International Guide to Foreign Currency Management Chicago, IL: Center for Futures Education 31. Skinner, Frank (2008) Pricing & Hedging Interest & Credit Risk Sensitive Investments Butterworth-Heinemann 32. Steward, Christopher, B & Lynch, J Hank (2008) “International Bond Portfolio Management” in Selected Topics in Bond Portfolio Management New Hope Pennsylvania: Fabozzi & Associates 33. Stuart, O. D. J. (2008) Economic Prospects: Vol 4 University of Stellenbosch Bureau of Economic Research. 34. Zubulake, Laura, A (1991) The Complete Guide to Convertible Securities Worldwide Hoboken, NJ: John Wiley & Sons. Read More