If a portfolio manager is neutral on which direction currencies will go… they fully hedge? Stupid question this late in the game but for some reason this never sticks.
Thanks
There is no perfect hedge. I think that If the portfolio manager has an active exposure in a foreign currency (intentional or not), he should not be considered neutral. I guess he would be considered neutral if currency risk is under the responsibility of a different manager (overlay manager or separated guidelines with separated benchmark).
maybe I misunderstood your question, but if he has no view on the currency market, he should be fully hedged, but the perfect hedge doesn’t exist. The best thing he could do is hedge the principal, or use a strategic hedge ratio. Replace “neutral” in my last comment by “passive”.
gotcha. Thanks. I know all the hedge ratio stuff (economic and translation risk) but for some reason my brain crapped out on this one. Time for some rest and relaxation.
Good luck
You can fully hedge fixed income currency risk because you know how much you are going to be paid (though technically if the bond defaults, then the non-defaulted forward/future exposes you to currency risk all over again).
With equities though, you can’t hedge perfectly. The choices are 1) hedge the principal, or 2) hedge your principal + expected return.
It depends on what you mean by “neutral.” You hedge if your expectations are more negative than the expectations of the market. If your expectations match those of the market, then you don’t hedge. If you have no expectations, than what are you doing managing money?
An IPS can be currency neutral in that it says that you don’t have the authority to make currency bets and must always hedge currency risk. Or a portfolio can be made currency neutral temporarily because you think that the exchange rates you’re exposed to may move against you. The former is a full-time currency neutral portfolio. The latter is still an actively managed currency exposure that just happens to be neutral right now. All IPSs that anticipate a major international component really ought to have a statement about whether currencies are required to be hedged or not.
Why manage money if you don’t have a currency view at all times?? It’s about isolating your core competencies. You may be good at analyzing balance sheets and company strategy, or making relative valuations between companies. You may be no good at knowing what currencies are going to do, or you may be good under certain conditions that you know about but not others. In that case, it makes sense to analyze the companies, but hedge out the risks of things that you don’t analyze well, like currencies. It improves your information ratio, which - as an active manager - is what you want.
There’s another reason to hedge: your client or IPS says you have to. Maybe your investor has someone else managing currencies separately, and they don’t want your currency exposures to throw off their overall risk allocations. So you analyze foreign stuff, because they want the risk premium for foreign equities or credits or real estate or whatnot, but they don’t want you making currency bets.
bchadwick: if you are investing overseas in a vacuum with no regard to currency, then I say you should not be investing overseas. Yes, stick to your core competencies, but do it by investing domestically.
If there is a currency overlay manager, then I take that to mean that I don’t bother with trying to hedge my currency exposure. But maybe that’s what you meant.
OK, be sure to write that down tomorrow morning in the AM section if you get the chance.
Ohhhh the sarcasm. I don’t think I’ll be writing that on the exam because I don’t expect “core competencies” to come up when the subject is whether or not hedge a currency exposure. Assuming there is no currency overlay manager, the decision is based on your expectations versus the market. You may have other views, but I’m sticking to what the curriculum says.
All I’m saying is that there are many reasons why you might want to have a currency neutral portfolio. One is an active bet (which you suggest is the only valid reason) where you think the currencies might run against you. But if that’s your argument, why stop at hedging? Why not actively short the currency, since you’re so good at having a view on everything?
Another is that you may be forced to by your client, who wants other people to be making those kinds of bets, perhaps because they think those other people do it better than you do. A third is that you want to expand your investment universe because you think your technique can work on a larger number of assets, but you don’t want to take on additional unpaid risk, because you’re not a currency master, so you simply hedge that part out. Sure, it’s best to have a view on currency if you’re any good at it, but just because you aren’t doesn’t mean that what you can do has no value in that market. Plenty of people are awesome at understanding companies, but don’t really have much talent at figuring out what the economy is going to do. If you are aware of this, and are willing to hedge or go market neutral, you can still add a lot of value.
If a currency hedge comes up on the exam - and it pretty much always does in some form or another - they’ll make it clear what the context is. They won’t make you guess at whether you are allowed to take a currency bet or not. So the debate about whether you should only manage money if you are good at analyzing everything on the planet simultaneously or not is unlikely to come up on the exam.
When I took the exam, there was definitely a question that basically asked if I should invest in some foreign sovereigns, and whether or not to hedge. It was effectively about taking an active bet given my view. (I rushed and forgot to subtract the forward premium from the local interest rate and got the wrong answer, so don’t forget to do that if something similar comes up on your exam. Fortunately, I passed anyway).