Slide 1: Meeting the Currency Challenge: Optimal Currency Hedging Benchmarks
Citi's Online Academy for Financial Institutions: Meeting the currency Challenge Optimal Currency Hedging Benchmarks for a EUR Based Bond and Equity Investor Dr Jessica James Managing Director, Global Head of Quantitative Investor Solutions, CitiFX and James Lemon Director, Global Custody FX Product
Slide 2: Introduction
Introduction y This presentation investigates the passive hedge benchmarks for international bond and equity exposures for a EUR based investor. y Our studies focus on the optimal hedge benchmark, optimal hedge rebalancing frequency and proxy hedging. For simplicity, we look at three international a
Slide 3: Optimal Hedge Benchmark
Optimal Hedge Benchmark y Choosing the optimal level of currency risk is the most important decision in terms of the impact on total return. y We recommend splitting the choice of the hedge ratio in two parts: y 1) Passive: choose the hedge benchmark. – When choosing the hedge benchmark one has to t
Slide 4: Relative Asset and Currency Volatilities
Optimal Hedge Benchmark – Relative Asset and Currency Volatilities WGBI: 1M Rolling Historic Volatilities (Annualised) y To illustrate the importance of hedging for bonds and equities 35% we compare historical volatilities of the EUR exchange rate 30% baskets(1) and underlying assets. 25% y The vola
Slide 5: WGBI: Historical Performance With Various Hedge Ratios
WGBI: Historical Performance With Various Hedge Ratios(1) Portfolio Performance for Various Hedge Ratios 180 170 160 150 140 130 120 110 100 90 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 0% 20% 40% 60% 80% 100% Source: Citi and Bloomberg. Sample: Jan-98–Sep-0
Slide 6: WGBI: Optimal Hedge Benchmark
WGBI: Optimal Hedge Benchmark y We recommend a high hedge benchmark of 80-100% for international bond exposures: – In our 10-year sample the 100% hedge ratio would have delivered higher returns than the unhedged portfolios. However, this is highly dependent on the choice of sample. Hedging clearly r
Slide 7: MSCI World: Historical Performance with Various Hedge Ratios
MSCI World: Historical Performance with Various Hedge Ratios(1) Portfolio Performance for Various Hedge Ratios 190 180 170 160 150 140 130 120 110 100 90 80 70 60 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 0% 20% 40% 60% 80% 100% Source: Citi and Bloomberg. S
Slide 8: MSCI World: Optimal Hedge Benchmark
MSCI World: Optimal Hedge Benchmark y Unlike for bonds, currency volatility in the MSCI World portfolio has been smaller than that of the underlying asset. y The marginal impact of the hedge on volatility falls as the hedge ratio increases: – For example, increasing the hedge ratio from 0% to 50% ha
Slide 9: 'Least Regret' – Example
‘Least Regret’(1) – Example 'Regret' as a Function of Basket Move and Hedge Ratio Maximum Regrets (Alternative Costs) from Incorrect Hedge Ratio 10.0% 8%-10% 9.5% 6%-8% 9.0% 4%-6% MAX REGRET 8.5% 2%-4% 0%-2% 10% 8.0% 8% 7.5% 0% 6% 20% 4% 7.0% 2% Hedge Ratio 40% 0% 6.5% 10% 6.0% 8% 60% 6% 4% 80% 2% 5
Slide 10: MSCI EM: Historical Performance With Various Hedge Ratios
MSCI EM: Historical Performance With Various Hedge Ratios(1) Portfolio Performance for Various Hedge Ratios 400 350 300 250 200 150 100 50 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 0% 20% 40% 60% 80% 100% Source: Citi and Bloomberg. Sample: Jan-98–Sep-09. MS
Slide 11: MSCI EM: Optimal Hedge Benchmark
MSCI EM: Optimal Hedge Benchmark y Without proxy hedging, the optimal hedge ratio for MSCI Emerging Markets has been 0% in the past. y Direct hedging of the emerging market currency portfolio has been too much of a return drag in the last decade: – On average, we find that it has cost 6.2% per year
Slide 12: MSCI EM: Proxy Hedging – Correlations
MSCI EM: Proxy Hedging – Correlations Correlations of Daily Log Changes in Spot (Maximum Correlation in Bold) EURAUD EURCAD EURCHF EURDKK EURUSD EURGBP EURHKD EURJPY EURNOK EURNZD EURSEK EURSGD EURARS 13.5% 29.5% 1.5% 4.0% 47.3% 24.3% 47.3% 23.9% 4.9% 12.9% 4.1% 39.1% EURBRL 29.7% 37.5% -12.4% 5.6%
Slide 13: MSCI EM: Proxy Hedging – Correlations
MSCI EM: Proxy Hedging – Correlations y Historical correlations of daily spot changes suggest that the USD has acted as a good proxy for most emerging markets. y The SGD has also been a good regional proxy for IDR, KRW, MYR, PHP, TWD and THB exposures. y For most CEE currencies it is difficult to fi
Slide 14: MSCI EM Proxy: Historical Performance with Various Hedge Ratios
MSCI EM Proxy: Historical Performance with Various Hedge Ratios(1) y To illustrate the impact of proxy hedging, we show the performance of a strategy, where the IDR, KRW, MYR, PHP, TWD and THB are all hedged via SGD and the rest of the EM MSCI via the USD. Portfolio Performance for Various Hedge Rat
Slide 15: MSCI EM Proxy Hedging via G10: Optimal Hedge Benchmark
MSCI EM Proxy Hedging via G10: Optimal Hedge Benchmark y Contrary to the direct hedge, the proxy hedge basked has been roughly carry neutral in the past (forward point gain +0.52% p.a.). y But what is the optimal hedge ratio for the proxy? y From a volatility point of view proxy hedging is not very
Slide 16: Hedge Implementation
Hedge Implementation y This presentation has so far dealt with the optimal choice of currency risk. y Having shown that hedging can reduce the volatility and drawdowns in international bond and equity portfolios, we now proceed to investigate the more technical questions of hedge implementation. y W
Slide 17: Monthly or Quarterly Forward Roll?
Monthly or Quarterly Forward Roll? y We recommend using quarterly forwards with the hedges being split between several roll dates in order to reduce exposure to liquidity risk: – There is little difference between monthly and quarterly forwards in terms of the forward point cost. The only difference
Slide 18: WGBI: Rebalancing Frequency at a Glance
WGBI: Rebalancing Frequency(1) at a Glance Max, Min & Average Hedge Ratios For Rebalancing Frequencies y There is a non-linear trade-off between the tracking error (2) 104% and rebalancing costs/volumes: 102% – The smallest tracking error of 0% would have been 100% achieved with daily hedge rebalanc
Slide 19: WGBI: Hedge Ratios for Various Rebalancing Frequencies
WGBI: Hedge Ratios for Various Rebalancing Frequencies 104% 103% 102% 101% w eekly 100% 99% 2 days 98% 97% 96% 95% 94% Source: Citi. Sample: Jan-98–Sep-09. 93% Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 104% 103% 102% 101% monthly 100% 99% bi-w eekly 98% 97%
Slide 20: MSCI World: Rebalancing Frequency at a Glance
MSCI World: Rebalancing Frequency(1) at a Glance Max, Min & Average Hedge Ratios for Rebalancing Frequencies 100% y We test the optimal rebalancing frequency on a 50% hedged MSCI World portfolio. 90% y Equities are volatile and create larger trading volumes: 80% – With 50% hedge ratio the monthly eq
Slide 21: MSCI World: Hedge Ratios for Various Rebalancing Frequencies
MSCI World: Hedge Ratios for Various Rebalancing Frequencies 104% 103% 102% 101% w eekly 100% 99% 2 days 98% 97% 96% 95% 94% Source: Citi. Sample: Jan-98–Sep-09. 93% Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 104% 103% 102% 101% monthly 100% 99% bi-w eekly 98
Slide 22: MSCI EM: Rebalancing Frequency at a Glance
MSCI EM: Rebalancing Frequency(1) at a Glance y There is an increase in trading costs and tracking error Max, Min & Average Hedge Ratios for Rebalancing Frequencies 80% in hedging emerging market equities relative to G10 equities and bonds (even with proxy hedging). 70% y The tracking error is large
Slide 23: MSCI EM: Hedge Ratios for Various Rebalancing Frequencies
MSCI EM: Hedge Ratios for Various Rebalancing Frequencies 85% 80% 75% 70% 65% 60% 55% w eekly 50% 45% 2 days Source: Citi. Sample: Jan-98–Sep-09. 40% Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 85% 80% 75% 70% 65% 60% 55% monthly 50% 45% bi-w eekly Source: Cit
Slide 24: Optimal Rebalancing Frequency
Optimal Rebalancing Frequency y The minimum tracking error can be achieved with daily rebalancing. All other rebalancing frequencies offer a cost saving relative to daily that can also be interpreted as ‘profit’ from strategy. y Monthly rebalancing is optimal: – Less frequent rebalancing than monthl
Slide 25: Intra-month Rebalancing Trigger
Intra-month Rebalancing Trigger y In order to reduce tracking error, we also recommend an MSCI EM: Tracking Error & Trading Cost as Function of Trigger Size intra-month rebalancing trigger: 3.5% – If the effective portfolio hedge ratio differs from the target none monthly 3.0% by more than the trigg
Slide 26: Managing Hedge Cash Flows
Managing Hedge Cash Flows Hedging USD into EUR: Quarterly Cash Flows from Hedges y Currency forwards are a popular choice for hedging, 15% because they are liquid and relatively cheap. 10% Quarterly Cash Flow From 100% Hedge y But forward hedges also have weaknesses: 5% – They produce large losses i
Slide 27: Conclusions
Conclusions y In this presentation we have investigated optimal hedging strategies for international bond and equity exposures for a EUR based investor. y We show that a 80-100% hedge ratio would have served well as a benchmark for international bonds. For equities we recommend a symmetric 50% hedge
Slide 28: Citi's AutoFX Solutions
Citi's Online Academy for Financial Institutions: Meeting the Currency Challenge Citi’s AutoFX Solutions September 2009 Strictly Private and Confidential
Slide 29: Introduction: Citi's AutoFX Solutions
Introduction Citi’s AutoFX Solutions Holistic solutions comprising multiple options for FX execution, based upon the AutoFX model including : y AutoFX for Settlements y AutoFX Share Class Hedging y AutoFX Passive Hedge Benefits include: y High quality relationship servicing, backed by Citi’s fully i
Slide 30: AutoFX Processing Model
AutoFX Processing Model Seamless integration of Investor and FX systems delivers fully STP solutions. Trade & FX Trade Investor Deal Secs Entries Passed Instruction Determination Trade on Cash (MT54X) Processing Centre Settles Account Pulse Client FX Processing Platform FX Confirmation (MT300) 1
Slide 31: Citi's AutoFX for Settlements
Citi’s AutoFX for Settlements The FX solution delivering transparency and choice in automated transactional FX execution. The advantages of AutoFX. AutoFX will simplify and streamline your transactional FX trades, so you gain a number of key advantages, including the following: y Flexibility. AutoFX
Slide 32: Citi's AutoFX Share Class Hedging
Citi’s AutoFX Share Class Hedging A highly flexible and transparent currency-hedging solution that reduces the currency risk associated with international investments in non fund base currency Share Classes. y Advantages – Citi’s Passive solution allows the Fund Managers to concentrate on day-to-day
Slide 33: Citi's AutoFX Passive Hedge
Citi’s AutoFX Passive Hedge A highly flexible and transparent currency-hedging solution that reduces the currency risk associated with international investments in today’s volatile markets. y Advantages – Passive solution. To smooth out fluctuations in currency valuations, Citi AutoFX Passive Hedge
Slide 34: FX Reporting
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Slide 35: Conclusion
Conclusion Awareness of the part played by currency exposures in potentially shaping investment performance has rarely been higher. The sharp swings in currency markets experienced in the second half of 2008, as investors fled to perceived safe havens, caused major headaches for international bond i
Slide 36: Thank you for joining our webinar Questions?
Thank you for joining our webinar Questions?
Slide 37: efficiency, renewable energy & mitigation
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