Currency volatility, political uncertainty, and trade tensions. Today’s headlines highlight the growing importance of effective risk management practices. How does foreign currency hedging fit into your risk management practices?
Didier Lavallée, Head of North American FX Sales for RBC Investor & Treasury Services (RBC I&TS), provides five insights into how a foreign currency hedging strategy can help Canadian institutional investors mitigate risk while optimizing execution efficiency.
1. Hedging provides the benefit of simplicity in an inherently complex environment
“Let’s go back to first principles,” comments Lavallée. “Hedging allows a portfolio manager to protect performance in the base currency.” This is particularly important in the current climate as global currencies are reacting to intensified geopolitical and macro-economic events.
“We’re operating in an environment in which a single Presidential tweet can impact performance by a few percentage points in only a matter of seconds,” notes Lavallée. “Compared to previous decades, long-term investing now requires some form of short-term protection.”
A decision to hedge can help simplify how investors operate in an environment that is both uncertain and increasingly short-term in focus, as it reduces one source of potential risk. In making this decision, investors need to take stock by first determining their risk appetite then deciding whether hedging will help alleviate these risks and market concerns as well as contribute to a desirable outcome.
2. A changing geopolitical environment requires rethinking and re-evaluation
“Historically, we did not need to consider hedging in the North American currency marketplace, as Canada and the US were working cooperatively and seen as close allies. In the current regime, this approach isn’t necessarily the case,” comments Lavallée. “For example, the renegotiation of the North American Free Trade Agreement and the possibility of further trade disputes between Canada and the US may provide an additional source of unwanted risk for the institutional investor.”
Currency hedging is one way to respond to a changing geopolitical environment. For Canadian investors with USD assets, the rise and fall of the home currency can have strong implications on performance. Take, for example, the period from November 2016 to October 2018, during which the CAD-hedged position outperformed the S&P 500 index by 5.4 percent.
For Lavallée, a passive approach can provide confidence that no matter how the CAD moves, the impact on investment performance will be limited. In the current context, obtaining this confidence can be increasingly more relevant and valuable.
3. Automated approaches can reduce decision friction and timing concerns
Currency hedging is one
way to respond to a
changing geopolitical
environment
Due to the volatility of currency markets, relying on manual execution to obtain a foreign currency quote can take time and create inconsistencies in rates. Multiply this time and inconsistency across investment managers with potentially offsetting orders, and the costs and operational risks can be high.
In contrast, by automating and consolidating orders using a hedging strategy, investors can standardize execution methods, reduce cost, and improve operational efficiencies. “Currency hedging can be offered using a completely customized and automated approach,” adds Lavallée. “One that is 100 percent decided by the client and built to meet client needs.”
This approach can mean less time and effort is spent making decisions about whether and how much to hedge, or how much risk exposure to retain, allowing portfolio managers to direct their focus to other operational activities.
4. Capturing optimization frees up focus for core activities
Different investors have different foreign currency implementation strategies, depending on factors including their level of comfort with currency exposure, views on the direction of currency markets, trading behaviours (including volume, size, and frequency), and internal resource capacity.
Currency hedging can be offered using a completely customized and automated approach
Regardless of the approach adopted, “an effective strategy encompassing FX hedging and execution tactics can help reduce costs and optimize the risk-adjusted return profile of investment portfolios,” says Lavallée. “This can mean capturing efficiencies throughout the operation, potentially leading to enhanced returns.”
5. New and emerging data solutions mean greater transparency at all stages of a transaction
Data visualization tools can provide enhanced oversight across all FX activities. “Current FX hedging approaches mean we are able to put analytics tools, the levers and dials of data, into the hands of portfolio managers, with complete transparency,” comments Lavallée. “This transparency also extends to TCA, or transaction cost analysis, which is an increasing focus for FX best execution practices.”
In summary, Lavallée contends that with growing allocations to new markets, heightened geopolitical risks, and an intensified focus on optimizing returns, effectively navigating foreign exchange exposure is a key element in overall asset management. As a result, North American institutional investors may need to revisit their FX operational model in order to define and implement an effective strategy.
Hedging 101
Foreign currency exposure is an inevitable consequence of international investing. Investors who obtain global asset exposure also take on foreign currency exposure, and thus the risk of accompanying foreign currency volatility on the portfolio. In response, institutional investors may choose to hedge their foreign currency exposure as a mechanism to mitigate its impact on a portfolio. Fundamentally, hedging is a way to reduce risk.
An institutional investor faced with foreign currency exposure can consider three alternatives:
- Do not implement a foreign exchange hedging strategy and maintain exposure to foreign currency fluctuations and the associated risk.
- Hedge foreign currency exposure risk by employing a passive hedging strategy that maintains a constant hedge ratio.
- Hedge foreign currency risk by varying the hedge ratio—that is, by implementing an active hedging strategy in accordance with the manager's day-to-day management decisions.
For institutional investors, hedging programs are customized to take into account individual risk and return objectives, as well as operational requirements. When implemented, a hedging program includes bespoke criteria such as how much to hedge, when to execute and the frequency and hedging horizon.
In conversation with Didier Lavallée