Global financial managers are taking a fresh look at the oldest and largest market in the world – foreign exchange – and discovering new ways to generate alpha, or expanded returns from their currency exposure. Increasingly, investment managers are paying closer attention to the risk in their portfolios, in particular the risk of currency fluctuations associated with their international investments. A growing number of managers are viewing FX as a distinct asset class and realising that managing their currency exposure can improve their return on investment. Another trend is the use of FX derivative products as an alternative to the over-the-counter (OTC) market, especially by technologically savvy fund managers.
Electronic trading has changed the landscape of the global FX marketplace by bringing enhanced transparency, easily accessible liquidity and reduced transaction costs to the portfolio manager. Hedge funds, CTAs and currency overlay managers are discovering the value of transacting their FX business electronically, and it has forever changed the way buy side customers execute their daily currency trading.
To hedge or not to hedge?
The amount of capital invested with global money managers has exploded in recent years, with over $1,000bn under management, and with it has emerged the question of what to do about currency risk. While global portfolio managers can either choose to manage their currency exposure internally or outsource the management, they must decide whether to hedge currency risk entirely, partially, or not at all.
If you are a US fund manager with a portfolio that includes Japanese equities, for example, you have risk – in this case, yen risk. Money managers have begun to realise that they cannot ignore the currency exposure in their portfolio, and that decisions must be made in order to achieve the best possible return. The first step is acknowledging that you have currency risk that may affect your fund’s performance; the second is deciding what, if anything, you want to do about it.
The problem with doing nothing is that currency valuations clearly have an impact on returns. If an overlay manager has a longer term investment horizon, but happens to enter the market during a period of high volatility, their returns could either be greatly improved or adversely affected within specific time frames, even though at the end of the horizon the net return could be zero.
It may be that currency exposures do balance out over time, but that can be a difficult point to make to investors, especially if they’re unhappy about taking a hit on returns because the euro fell by 10 percent despite expectations that it would strengthen. Currency management can help preclude a mismatch of investment horizon versus the movement or fluctuation in the currency. Studies have demonstrated that actively managing currency risk can generate more consistent and less volatile returns and positively impact a portfolio. If managers don’t do it, they potentially have a problem.
Hedging strategies
Once the decision to actively manage currency risk is made, overlay managers must then decide what strategy is best for their portfolios. Most managers choose from one of three strategies: passive, active or dynamic management strategies.
Passive approach:
This approach utilises a fixed hedge ratio against a benchmark, either unhedged, fully hedged or partially hedged. For example, a manager may track performance by correlating CME S&P 500 futures, FTSE, and Nikkei 225 values against CME sterling and Japanese yen futures and track returns by monitoring the movement of the indices versus the return on the currency exposure. If the Nikkei increases 2 per cent and the yen falls 2 per cent, a manager who has fully hedged by selling CME Japanese yen futures has also successfully managed his yen overlay exposure. If he/she were not hedged or partially hedged, his returns would have been negatively impacted. A passive overlay approach is easy to implement, simple to monitor (CME FX futures are publicly listed), low in cost and does not necessarily require an overlay specialist.
Active approach:
An active currency overlay management approach can exploit short-term opportunities that a passive approach would miss. For example, overlay managers using an active approach could be more than 100 per cent hedged in a particular currency if they believe strongly that that currency will move sharply in a certain direction. In addition, overlay managers can use an active approach along with a passive approach, and can outsource some of the risk to additional managers, while maintaining a passive approach in-house.
Dynamic approach:
This approach utilises options pricing theory as an insurance policy to manage currency exposure. Among the benefits of this approach are the mitigation of cash flow problems, the lack of need to pay large upfront premiums and it reduces worry about adverse currency movement, since the option will only be exercised if it is in the money.
All three of the above strategies can be easily managed by using CME FX futures or options on futures products. In addition, overlay managers can execute their transactions anonymously 23 hours per day on the CME Globex electronic trading platform, monitor their positions in real time and reduce transaction costs dramatically compared to the OTC market.
Transparency, speed and liquidity
Transparency:
In contrast to the call around tradition of the OTC market, the electronic markets at CME are completely transparent. CME offers direct electronic access to all market participants on CME Globex for all products. While the bid/offer in the cash FX market is usually only accessible to large traders via prime brokerage platforms or other single platforms, CME traders can view hundreds of bids and offers and participate directly in establishing the going price of any trade in a central marketplace. Prices are not skewed to favour a dealer’s position as they may be in the OTC market, which factors unknown spread costs into the deals.
What you see is what you get. There are no hidden costs and the spreads are the same for all customers. Whether you are a fund manager, individual investor, or professional trader, CME offers equal access and the same liquidity for all traders. In addition, there are competitive fee structures in place at the CME to suit all customer segments.
Speed:
Quick execution has not been a focus of currency overlay managers, who typically trade long-term positions. But that point of view is changing. Overlay managers are increasingly adding high velocity strategies to their trading style to increase alpha, another reason for currency overlay managers to trade CME FX.
The speed of electronic execution at CME can help reduce slippage, lower costs and thereby improve returns, whether the goal is active currency management for return or passive management for hedging risks.
Liquidity is always a key issue for currency overlay managers, who may need, for example, to execute a trade for €100m at any time.
CME has the liquidity to handle €100m trades (800 contracts) easily, and it’s available for all to see on our web site – at www.cme.com/equivalents. E-quivalents is a free application that displays CME FX volume and prices in spot equivalent terms. There is nothing else out there quite like it.
CME E-quivalents enables viewers to see the top five bids and offers in real-time, basically around the clock, in spot market convention, which makes it easy to compare FX cash and futures prices.
The site also displays options quotes on European style euro and yen options, as well as forward rate quotes in six major currencies from ICAP, the world’s largest interdealer broker. Banks act as market-makers to provide liquidity around the clock for CME FX products.
CME’s euro futures prices regularly show a one-point bid/ask spread, and the average size of each bid and offer rivals the cash market in liquidity (see the screenshot above).
Alternative asset class
In addition to trading FX for currency overlay, financial managers are increasingly looking to FX as an alternative asset class and finding that it can add value to a diversified portfolio.
While the returns in currencies may not be as consistent as they can be in equities or in fixed income, profit opportunities are always available because of the continual fluctuations in currency rates. And, unlike equities, there are no bear markets in FX. When one currency is rising, the other is falling. Even if volatility is low, trading options can be a way to add alpha to a portfolio while the overall currency market trades sideways.
Many money managers also are attracted to FX as an asset class because they consider it a non-correlated asset. The long-term average of the correlation of the foreign exchange movements with the underlying equity exposure is close to zero1. This provides additional sources of return for money managers as it gives additional opportunities to generate alpha.
Growth of FX futures
Introduced by CME in 1972, FX futures were designed to help manage the risks of floating currency rates that resulted from the US abandonment of the gold standard in 1971. The CME FX futures marketplace has grown and changed significantly since then. In 2004 CME FX traded a notional value of $6200bn, accounting for about 5 percent of the global FX spot market. CME hosts the trading of more than 95 percent of all FX trades executed on US exchange, and is the largest regulated marketplace for FX trading in the world.
CME offers virtually 24-hour electronic trading on 16 currencies traded against the US dollar and 17 cross-rate products. The CME market appeals to a wide range of participants. American style options are offered on all the currencies, and European style options are available on the euro and Japanese yen. All CME FX options on futures can be traded electronically on the CME Globex platform, and via open outcry on the CME trading floor. However, American style options are not available on CME Globex during regular trading hours, but can be executed via open outcry.
FX trading on the CME Globex electronic platform has grown spectacularly. About 90 per cent of FX volume at CME is now electronic. The efficiency, reliability and speed of our electronic ongoing provide opportunities for hedgers and alpha seekers alike. Fluctuations have offered ongoing opportunities.
CME FX can now also be traded on the Reuters Dealing 3000 platform, providing spot-equivalent prices with straight-through processing. CME FX quotes can be viewed by approximately 18,000 FX professionals worldwide, most of whom are interbank FX traders.
Additional advantages of FX futures
Costs: CME offers flexible, competitive pricing for a variety of different customer types. Trading fees for currency futures are comparable to OTC market prices, and in many cases, less.
Access: There are multiple providers of connectivity for trading access to CME. Customers who need a futures broker can consult a listing of brokers on the CME web site URL
Security: Counterparty risk is not a concern with CME futures, so customers do not have to worry about the performance of the other party to the trade. Through its clearing house, CME offers a system of unparalleled financial safeguards. The clearing house also matches, settles and guarantees all trades.
The guarantor and clearing method of a marketplace are extremely important, but not always given due consideration. The type of clearing guarantee offered at CME is generally not available on OTC FX platforms.
1 From “Currency Overlay, A Practical Guide” by Hai Xin
Rick Sears is managing director of CME Foreign Exchange.
