Efficient currency risk management takes time, skill and resources. Outsourcing to a specialist can be a cost-effective way to reduce the negative impact of FX volatility on portfolio performance. Currency volatility is on the rise. After several years of relative stability in global foreign exchange markets, 2015 will be remembered as the year when the economic status quo of the past five years was turned on its head. The dollar has so far surged against almost all other currencies in 2015, while emerging markets currencies and the euro have slumped. This atmosphere of uncertainty in global currency markets is unlikely to go away anytime soon.

How FX volatility threatens performanceAs these economic tectonic plates have shifted, some currencies across the globe have see-sawed against one another. According to Marc Tuehl, Global Head

of FX Overlay at HSBC, “this volatility in global foreign exchange markets is likely to continue, driven by the diverging actions of central banks across the world.” And this could have implications for investors with portfolios of international investments. Sharp movements in the value of the underlying currency of the asset in which you are invested, could do serious damage to a portfolio’s performance.

Tuehl says that currency is a much bigger risk-contributor to portfolios of international investments than appreciated. “It’s important to remember you are not just invested across asset classes, but also across geographies. So not only are you exposed to the risks of the asset class itself, but also to the currency risk,” he says. And in addition to the top-level risk of a currency going up or down in value, there are other factors that investors in international assets need to take into account. “A thorough analysis

FX volatility: is it time to consider dynamic hedging?HSBC Markets Insight Series - 2/3, 30 November 2015

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of the portfolio is critical for investors to get a clearer picture of the kinds of currency risks they are exposed to. They also need to execute and manage their strategy, and take into account the impact of other factors, like regulation.”

Passive hedging is just that Investment managers have traditionally used a passive hedge strategy to mitigate the risks of currency movements. Put simply, if you are a UK fund manager invested in US equities, which are denominated in dollars, then it is sensible to hedge your currency risk by buying Sterling pounds forwards (selling the US$). That way, if the value of the dollar falls against the pound, then your dollar losses are effectively balanced out by your sterling gains. However, Garrod Treverton, Director of FX Fund Solutions Sales at HSBC, says that investors who take a passive hedging approach, face two potential problems: cash flow risk and opportunity cost.

Passive hedging is beneficial if the underlying foreign currency of the equities or bonds in which you are invested, falls. The question is: what if the value of the underlying currency rises? “There will be two effects,” says Treverton. “Not only could investors miss out on those gains, they could also need to find more cash to fund their hedge.” The problem with taking a passive approach to currency management, according to Treverton, is that once your hedge is in place, it is static: by its nature it does not adapt to changes in market conditions.

“It can be a huge potential liquidity problem and in some cases – when currencies move sharply against one another – investors may need to sell positions to fund their hedge,” says Treverton. This is because the higher the value of the foreign currency against your home currency, the more it will cost you to maintain your hedged position.

To put that into perspective, for example: 12 months from 2014 to 2015 a EUR investor passively hedging 100% of their USD assets would have lost up to 25% on their hedge. Similarly, a UK investor hedging 100% of their US assets would have been pleased when GBP climbed 16% vs the USD in 2013 – 2014, but immediately faced with a very real challenge when GBP fell 15% in the following year.

Hedge ratio in relation to Spot market move

• A UK investor passively hedging 100% of their US assets would have accumulated over 8.5% of positive returns on their hedge during the GBP rally, only to end up down more than -5.5% after the sell-off.• Cashflows assume monthly rolling FX swaps

A dynamic approach to currency management*According to Treverton, having a currency risk management solution can help with adaption to changes in the local currency, taking into consideration volatility and/or momentum, whether that results in a decrease in its value, or an increase. “Managing currency exposure is as much about managing potential opportunities as it is about managing potential risks” he says. “From what we have seen, the market has certainly evolved in the wake of the financial

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crisis which saw large hedging losses across the industry. The objective was focussed too heavily towards return and not enough on risk management. The fall out was that we moved to a ‘no hedge’ strategy, then to a ‘passive hedge’ strategy and now investors are increasingly taking a dynamic approach to currency hedging focussing on protection and risk management primarily.”

Hedge ratio in relation to Spot market move

• Dynamically adjusting the investor’s hedge ratio, aiming to hedge in adverse market moves, whilst reducing that hedge in positive moves can result in a smoother liquidity profile, or even outperformance.

• Cashflows assume monthly rolling FX swaps

But which factors should investors consider when looking at currency risk management? Tuehl says the first step for any investor with an international portfolio is to identify the currency risks embedded in that portfolio. “Only once you’ve pinpointed the specific currency risks, can you set about mitigating those risks. And it is not just financial risks you are mitigating, but cash flow and operational risks too,” he says. Treverton adds that by using a dynamic strategy you can smooth out the liquidity profile of your hedging strategy across the investment horizon. “For example, running

out of cash is not the only challenge. If your currency investments produce an excess of cash, that cash will need to be re-invested to prevent cash drag: uninvested cash does not participate in the market and has no performance contribution.”

The investment time horizon is another factor that needs to be considered. “Whilst it is optimal to build the hedging strategy around the investment tenor, performance measurement will be quantified in a shorter timeframe,” says Treverton. “This supports a dynamic currency risk management approach.”*Non-discretionary

Opportunities offered by outsourcingOnce an investor has recognised the need for a strategic approach to currency management, the next challenge lies in the actual implementation of that strategy. Balancing risk and return is one thing but the day-to-day considerations of managing a currency strategy, quite another. “Currency management is resource intensive. It takes time, people and an investment in infrastructure,” explains Tuehl. “Most of our asset management and pension fund clients tend to focus on the selection of underlying assets, such as bonds and equities, whilst leaving open FX risk”

Regulation is another crucial factor to bear in mind. The regulator’s spotlight has shone brightly on the FX markets. In particular, there is a demand for transparency, says Treverton. “You need to be able to prove everything you do through a fully transparent audit and reporting trail. And it’s likely there will be more and more regulatory requirements in the future too. There will be costs attached to

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Outsourcing can cut costs, cut risk and improve performance see page 4

Outsourcing can cut costs, cut risk and improve performance

Three aspects international portfolio managers need to consider in a time of increased currency volatility:• Pinpoint the currency risks: How are the underlying currencies affecting the

performance of my international investments? Have I identified where my potential currency risks lie?

• Find the appropriate strategy: In times of volatility, is my currency management strategy flexible enough to mitigate the risks, while at the same time take advantage of the potential opportunities?

• Implement the strategy: Have I taken into consideration the costs of implementing a hedging strategy, the infrastructure required, and the time and resources it will use up?

DisclaimerThis article should not be regarded as investment research for the purposes of the rules of the Financial Conduct Authority (“FCA”) or any other relevant regulatory body. Any charts and graphs included are from publicly available sources or proprietary data. Figures included in this article may relate to past performance or simulated past performance (together “past performance”). Past performance is not a reliable indicator of future performance. Reproduction of this article, in whole or in part, or disclosure of any of its contents, without prior consent of HSBC, is prohibited. This document is not intended for distribution to, or use by, retail clients as defined in the FCA rules, or any person or entity in any jurisdiction or country where such distribution would be contrary to law or regulation. You are solely responsible for making your own independent appraisal of and investigation into the products, investments and transactions referred to in this article and you should not regard any information in this document as constituting investment advice. HSBC is not responsible for providing you with legal, tax or other specialist advice. Except in the case of fraudulent misrepresentation, neither HSBC nor any of its officers, directors, employees or agents accepts any liability for any loss or damage arising out of the use of all or part of this material.Issued and approved for publication to Professional Clients and Eligible Counterparties only by HSBC Bank plc. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation AuthorityThis material does not constitute Investment Research. It has been prepared by a member of the sales and trading department of HSBC Bank Plc and/ or its affiliates, collectively known as (“HSBC”) and not by HSBC’s Research Department. This is a desk view & not a recommendation. Investors must make their own determination & investment decisions. This material does not constitute Investment Research. It has been prepared by a member of the sales and trading department of HSBC Bank Plc and/ or its affiliates, collectively known as (“HSBC”) and not by HSBC’s Research Department. This is a desk view & not a recommendation. Investors must make their own determination & investment decisions.”

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this, both financial and operational.”Outsourcing currency management can

be a cost effective way to overcome these problems, according to Tuehl. “A third-party professional currency manager can pinpoint the currency risks in a client’s portfolio, implement a strategy and importantly, also provide the infrastructure,” he says. “In our case, we invest significantly in this infrastructure, which enables clients to benefit from our economies of scale. We will also provide transparent and detailed

management information about risk and performance, which should help address regulatory requirements.”

Ultimately, there is no such thing as a perfect hedging strategy, according to Treverton and Tuehl, but in times of currency volatility, and when regulations tend to restrict flexibility in FX markets, it could pay to take a dynamic approach. “It is possible to manage risks in a systematic framework, even if you do not have control over the factors around it,” Tuehl concludes.