Second Investment Course

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Second Investment Course November 2005

• Topic Eight
• Currency Hedging Using Derivatives
• in Portfolio Management

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Using Derivatives in Portfolio Management

• Most long only portfolio managers (i.e.,
  non-hedge fund managers) do not use derivative
  securities as direct investments.
• Instead, derivative positions are typically used
  in conjunction with the underlying stock or bond
  holdings to accomplish two main tasks
• Repackage the cash flows of the original
  portfolio to create a more desirable risk-return
  tradeoff given the managers view of future
  market activity.
• Transfer some or all of the unwanted risk in the
  underlying portfolio, either permanently or
  temporarily.
• In this context, it is appropriate to think of
  the derivatives market as an insurance market in
  which portfolio managers can transfer certain
  risks (e.g., yield curve exposure, downside
  equity exposure) to a counterparty in a
  cost-effective way.

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The Cost of Synthetic Restructuring With
Derivatives
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The Hedging Principle (cont.)

• Consider three alternative methods for hedging
  the downside risk of holding a long position in a
  100 million stock portfolio over the next three
  months
• 1) Short a stock index futures contract expiring
  in three months. Assume the current contract
  delivery price (i.e., F0,T) is 101 and that
  there is no front-expense to enter into the
  futures agreement. This combination creates a
  synthetic T-bill position.
• 2) Buy a stock index put option contract expiring
  in three months with an exercise price (i.e., X)
  of 100. Assume the current market price of the
  put option is 1.324. This is known as a
  protective put position.
• 3) (i) Buy a stock index put option with an
  exercise price of 97 and (ii) sell a stock index
  call option with an exercise price of 108.
  Assume that both options expire in three months
  and have a current price of 0.560. This is
  known as an equity collar position.

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1. Hedging Downside Risk With Futures
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The Hedging Principle
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1. Hedging Downside Risk With Futures (cont.)
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2. Hedging Downside Risk With Put Options
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2. Hedging Downside Risk With Put Options (cont.)
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3. Hedging Downside Risk With An Equity Collar
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3. Hedging Downside Risk With An Equity Collar
(cont.)
Terminal Position Value
Collar-Protected Stock Portfolio
108
97
97
108
Terminal Stock Price
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Zero-Cost Collar Example IPSA Index Options
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Zero-Cost Collar Example IPSA Index Options
(cont.)
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Another Portfolio Restructuring

• Suppose now that upon further consideration, the
  portfolio manager holding 100 million in U.S.
  stocks is no longer concerned about her equity
  holdings declining appreciably over the next
  three months. However, her revised view is that
  they also will not increase in value much, if at
  all.
• As a means of increasing her return given this
  view, suppose she does the following
• Sell a stock index call option contract expiring
  in three months with an exercise price (i.e., X)
  of 100. Assume the current market price of the
  at-the-money call option is 2.813.
• The combination of a long stock holding and a
  short call option position is known as a covered
  call position. It is also often referred to as a
  yield enhancement strategy because the premium
  received on the sale of the call option can be
  interpreted as an enhancement to the cash
  dividends paid by the stocks in the portfolio.

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Restructuring With A Covered Call Position
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Restructuring With A Covered Call Position (cont.)
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Some Thoughts on Currency Hedging and Portfolio
Management
Question How much FX exposure should a portfolio
manager hedge?
Weakening CLP
Strengthening CLP
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Conceptual Thinking on Currency Hedging in
Portfolio Management

• There are at least three diverse schools of
  thought on the optimal amount of currency
  exposure that a portfolio manager should hedge
  (see A. Golowenko, How Much to Hedge in a
  Volatile World, State Street Global Advisors,
  2003)
• 1. Completely Unhedged Froot (1993) argues that
  over the long term, real exchange rates will
  revert to their means according to the Purchasing
  Power Parity Theorem, suggesting currency
  exposure is a zero-sum game. Further, over
  shorter time frameswhen exchange rates can
  deviate from long-term equilibrium
  levelstransaction costs make involved with
  hedging greatly outweigh the potential benefits.
  Thus, the manager should maintain an unhedged
  foreign currency position.
• 2. Fully Hedged Perold and Schulman (1988)
  believe that currency exposure does not produce a
  commensurate level of return for the size of the
  risk in fact, they argue that it has a long-term
  expected return of zero. Thus, since the
  investor cannot, on average, expect to be
  adequately rewarded for bearing currency risk, it
  should be fully hedged out of the portfolio.

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Currency Hedging in Portfolio Management (cont.)

• 3. Partially Hedged An optimal hedge ratio
  exists, subject to the usual caveats regarding
  parameter estimation. Black (1989) develops the
  notion of universal hedging for equity
  portfolios, based on the idea that there is a net
  expected benefit from some currency exposure.
  (This is attributed to Siegels Paradox, the
  empirical relevance of which is questionable in
  this context.) He demonstrates that this ratio
  can vary between 30 and 77 depending on a
  variety of factors.
• Gardner and Wuilloud (1995) use the concept of
  investor regret to argue that a position which is
  50 currency hedged is an appropriate benchmark
  for investors who do not possess any particular
  insights and FX rate movements.
• A variation of the partial hedging approach is
  that different asset classes should have
  different hedging policies. For instance, Black
  (1989) also suggests that foreign fixed-income
  portfolios should be fully (i.e., 100) hedged
  under the universal hedging scheme. This is
  partly due to the fact that currency volatility
  represents a larger percentage of the volatility
  to a fixed-income position than the volatility of
  an equity holding.

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Hedging the FX Risk in a Global Portfolio Some
Evidence

• Consider a managed portfolio consisting of five
  different asset classes
• Chilean Stocks (IPSA), Bonds (LVAC Govt), Cash
  (LVAC MMkt)
• US Stocks (SPX), Bonds (SBBIG)
• Monthly returns over two different time periods
• September 2000 September 2005
• September 2002 September 2005
• Five different FX hedging strategies (assuming
  zero hedging transaction costs)
• 1 Hedge US positions with selected hedge ratio,
  monthly rebalancing
• 2 Leave US positions completely unhedged
• 3 Fully hedge US positions, monthly rebalancing
• 4 Make monthly hedging decision (i.e., either
  fully hedged or completely unhedged) on a monthly
  basis assuming perfect foresight about future FX
  movements
• 5 Make monthly hedging decision (i.e., either
  fully hedged or completely unhedged) on a monthly
  basis assuming always wrong about future FX
  movements

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Investment Performance for Various Portfolio
Strategies September 2000 September 2005
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Investment Performance for Various Portfolio
Strategies September 2002 September 2005
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Sharpe Ratio Sensitivities for Various Managed
Portfolio Hedge Ratios
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Currency Hedging and Global Portfolio Management
Final Thoughts

• Foreign currency fluctuations are a major source
  of risk that the global portfolio manager must
  consider.
• The decision of how much of the portfolios FX
  exposure to hedge is not clear-cut and much has
  been written on all sides of the issue. It can
  depend of many factors, including the period over
  which the investment is held.
• It is also clear that tactical FX hedging
  decisions have potential to be a major source of
  alpha generation for the portfolio manager.
• Recent evidence (Jorion, 1994) suggests that the
  FX hedging decision should be optimized jointly
  with the managers basic asset allocation
  decision. However, this is not always possible
  or practical.
• Currency overlay (i.e., the decision of how much
  to hedge made outside of the portfolio allocation
  process) is rapidly developing specialty area in
  global portfolio management.