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Portfolio Management And Currency Risk
Introduction Fund managers have different foreign exchange requirements than Corporates because foreign exchange exposures occur because of investment activities as opposed to trade activities. Fund managers are often working within a benchmarked framework and managing foreign exchange risks incorrectly can give rise to unwanted and unexpected deviation on returns even when trying to stay at benchmark. Fund managers should be aware of not only the benchmarks set for them but how to manage to the benchmark return. This is often more complex than may first appear as benchmark indices are set periodically and fund size changes can affected the currency weighting in unexpected ways.
Fully Hedged PortfoliosMost fund managers run international bond portfolios fully hedged which means that for every foreign bond exposure they have a corresponding hedge in place. Usually the hedge takes the form of a forward sale of foreign currency for Australian Dollars normally on a rolling three month basis. In practical terms this means that on purchasing a foreign bond the fund manager should enter a swap or (FX forward) contract. This means that on the near leg of the swap they can buy the foreign currency against AUD (to pay for the bond) and the second leg is for the sale of the foreign currency against the AUD and neutralises the FX risk. NB: I have seen fund managers execute a
spot to buy the foreign currency and then an outright deal to sell the foreign currency forward - the net effect is the same as a swap except the fund pays an unnecessary spread in the spot market. Once the hedges are due for settlement the fund simply executes another swap. The near leg is equal and opposite to the maturing deals (except the rate is now the current spot) and the second leg reinstates the forward hedge.
The portfolio manager also needs to decide which currency to keep constant, Australian Dollars or the foreign currency. In general it is the foreign currency which should be kept constant in line with the value of the bond holdings. If the foreign currency hedge amount is kept constant be aware that each roll date will give rise to an AUD profit or loss on the hedge. Also at each roll date the value of the foreign bond needs to be taken into account and the hedge adjusted accordingly to make sure the portfolio is not over or under hedged.
Unhedged PortfoliosHowever when a fund manager is running a portfolio unhedged then foreign currency should be bought and sold as needed to satisfy the underlying transaction. These transactions should be executed when the underlying assets are purchased or sold and have value dates matching the settlement terms of the underlying asset, for example in equities its usually T+5.
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