A smarter way to look forward on foreign exchange risk

Michael Sommers

By

10/02/2017

OPINION | In the face of an uncertain currency outlook led by diverging monetary and fiscal policies, institutional investors need to think especially carefully about how to manage their currency risk.

For local institutions, decisions about whether to keep certain foreign exchange (FX) risks within a portfolio unhedged, or to hedge with options or forwards instead, depends on their view about the future trajectory for the Australian dollar.

Frontier Advisor’s modelling suggests a long-term allocation to foreign exchange call options can complement using FX forwards during periods of sharp movements in currency markets. In that case, however, periods of low and falling volatility then have the potential for losses from the performance drag, through premiums paid.

If the expectation is that the currency will fall, but there is a chance it could rally (and it usually rallies quickly), then a call option provides a useful portfolio tool for scaling into an exposure during times of uncertainty. If the outlook is for a stronger Aussie dollar, then an investor should use a forward, but be mindful that should the currency fall, returns will be forgone.

The Australian dollar can be a friend to investors, but it can also be a foe.

Those with investments denominated in foreign currencies are exposed to movements in the Australian dollar against that currency. If the Aussie strengthens, then the return on that overseas investment is reduced when translated into local currency terms. Of course, if the Australian dollar weakens, then returns will be enhanced. In the case of equity market stress periods, when the Australian dollar usually weakens, the equity-driven loss will be dampened.

Hedged v unhedged

Given the ongoing volatility of the Australian dollar, it is important to manage this effectively.

Investors can reduce their sensitivity to fluctuations by using currency hedges. Usually this means using currency forward contracts that lock-in the exchange rate (called a forward rate) for a fixed period (such as a month). The investor earns a small return based on the interest rate differential between Australia’s dollar and the overseas currency, earning a profit if Australian interest rates are higher than the other country or a loss if lower.

The benefit of using currency forwards is protection of overseas returns when the Australian dollar strengthens. However, it also means that an investor cannot enjoy the benefits, such as equity-driven loss dampening, when the Australian dollar falls, since they will be locked into exchanging at the pre-agreed higher exchange rate.

We believe holding a certain level of unhedged currency exposure is a good idea, particularly within major currency pairs. Most commonly, this will mean protection against fluctuations in the US dollar.

Not only does currency exposure improve the risk profile and diversification of the portfolio, but also it is one of the only asset classes (in addition to put options) in an investor’s portfolio that can still offer some form of downside protection (assuming the local dollar weakens during an equity-stress, which needn’t always be the case).

Bonds have been helpful in the past when yields were higher but, with yields at historically low levels, they are less likely to offer that type of equity-loss offset.

Currency options essentially allow an investor to have their cake and eat it, too…at a cost of course. There’s no free lunch, or cake, in finance.

The investor benefits when the Australian dollar falls but won’t lose when it rallies. The cost, or premium paid, on an option is offset by the benefit if the Aussie rises, but is essentially wasted whenever the local dollar falls.

A long-term comparison

As with insurance, it’s a good outcome when you don’t use the option because that means the Australian dollar has weakened, which enhances returns. Or think of it this way, when was the last time you complained about wasting money on fire insurance for your home in a year when your home didn’t burn down?

The accompanying chart highlights the performance of US dollar exposure from an Australian investor’s standpoint, and includes a fully hedged return profile using FX forwards, as well as the performance profile resulting from using rolling one-month FX call options.

There are periods when using call options outperformed remaining unhedged, particularly during periods of sustained increases in the Australian dollar against the US dollar (2001 to 2004, 2006 to 2008 and the period after the global financial crisis), which makes sense because this is the period when an investor’s US dollar return was reduced because it was worth less in Australian dollar terms.

Using call options underperformed when the Aussie weakened. This was most obvious in October 2008 but also at different periods over the last three years. This difference reflects the cost of the option, which detracts from any benefits gained when the Australian dollar falls. Overall, the profits may be lower relative to an unhedged portfolio but the losses are vastly reduced, which leads to an improved risk-return profile.

 

Michael Sommers is a senior consultant with Frontier Advisors.