in this question the SWF has a long term view and no need for liquidity. also, it is tilted toward equity (if it was Fixed income then the FX hedge is more important). Furthermore, since the exposure is mainly on EM, one can think that hedging or actively managing the currency would be risky.
it sounded like everything was pointing towards a strategy where the currency doesn’t have to be hedged. i would have chosen answer C.
but the answer of this exercise is advising to do a an “active currency management”.
does anybody have an explanation for this?
Post da problem if you want a response.
Sure, Here is the problem
Kalila Al-Khalili has been hired as a consultant to a Middle Eastern sovereign wealth fund.
The fund’s oversight committee has asked her to examine the fund’s financial characteristics and recommend an appropriate currency management strategy given the fund’s Investment Policy Statement. After a thorough study of the fund and its finances, Al-Khalili reaches the following conclusions:
- The fund’s mandate is focused on the long-term development of the country, and the royal family (who are very influential on the fund’s oversight committee) are prepared to take a long-term perspective on the fund’s investments.
- The fund’s strategic asset allocation is tilted towards equity rather than fixed-income assets.
- Both its fixed-income and equity portfolios have a sizeable exposure to emerging market assets.
- Currently, about 90% of exchange rate exposures are hedged although the IPS allows a range of hedge ratios.
- Liquidity needs of the fund are minimal, since the government is running a balanced budget and is unlikely to need to dip into the fund in the near term to cover fiscal deficits. Indeed, the expected lifetime of country’s large oil reserves has been greatly extended by recent discoveries, and substantial oil royalties are expected to persist into the future.
Based on her investigation, Al-Khalili would most likely recommend:
- active currency management.
- a hedging ratio closer to 100%.
- a narrow discretionary band for currency exposures.
I would guess A. They are prepared to take a long term perspective. In the long run currency fluctuations are expected to net to zero so hedging may be an unnecessary expense.
I do like how they explain that C is incorrect: C is incorrect because A is correct.
The question to ask yourself is this: is there a reason to limit currency exposure?
The answer is: no.
Its cause the Govt doesn’t need liquidity otherwise they it have invested more conservatively. Also, improvements in oil reserves are a positive which could provide good cash flow in the future. Both these factors point towards a high risk taking ability and a high assumed willingness and hence option A.