Currency hedging | Feature


which drive growing demand for active cur- rency hedging. There is first the transition towards a “two speed world” characterised by the stark divergence in interest rates between Europe and the US. A second fac- tor is the increasing frequency of geopoliti- cal events which lead to higher levels of forex volatility. A third factor is the growing awareness of forex cost, partly due to the introduction of Mifid II. Growing volatility as a result of Brexit might be a case in point. For Mark Hedges, chief investment officer of the Nationwide Pension Fund, now might be an opportune time to cash in on some of the gains. “We could probably do some hedging on a macro level, one of the strategies we are currently looking into is locking in some of the value of the translation risk. “We have about $600m to $700m in our portfolio, a 10% fall in ster- ling increases that by $70m (£56.7m), so it starts to become appreciable to hedge that by overlaying our strategy with some cur- rency forwards,” Hedges says. Yet he is also acutely aware of the risks that come with such an approach. “If you do that, you end up losing out on further falls,” he adds. “So whenever you overlay the strat- egy with currency forwards you are essen- tially forming a view that sterling is under- priced, but you don’t know how long it will be under-priced for.” Bac Van Luu, head of currency and fixed income strategy at Russell Investments, holds a similar view. “With sterling trading at historically low levels vis-à-vis the US dollar, now is a good time for UK investors to assess the impact that currency expo- sures have on their portfolio risks. “Investors that have so far been currency- unhedged and therefore benefitted from the strength of the US dollar may consider hedging now to lock in these gains,” he adds. “Leaving currency risk unmanaged is not the best long-term choice, in our view.” Catherine Doyle, investment specialist in the real return team at Newton Investment Management, says that while each approach has its merits, given the uncertainty of any


Brexit outcome, caution might be in order. “The decision to hedge depends on an assessment of the magnitude of the risk,” she adds. “Brexit is likely to be binary in outcome and a case can be made for an out- sized move in either direction. It is, however, impossible to call and in our real return strategy we have adopted a neutral stance vis-à-vis our sterling exposure.” Passive currency hedging is generally used when the preference is not to take a view and it removes the need to take active man- agement decisions. However, we think


levels could erode is the pound flash crash in 2016. During October of that year, the pound suddenly dropped 10% compared to the pre- vious trading day in the course of just a few minutes.


One factor behind such sudden market movements is the changing nature of liquid- ity providers as a result of banking regula- tion introduced in the aftermath of the 2008 crisis, Metzler’s Achim Walde says. Traditional risk takers such as banks have withdrawn from the market by passing on challenging trading positions, which does


Leaving currency risk unmanaged is not the


best long-term choice, in our view. Bac Van Luu, Russell Investments


active management of currency can be a valuable tool and we have used it in the past to our advantage to express a strong view. In this instance, there is so little visibility as to the outcome of Brexit that we have cho- sen to have minimal floating currency exposure,” she adds.


LIQUIDITY CONCERNS Regardless of which form of currency hedg- ing investors pursue, liquidity is always a factor they should keep in mind, Woolmer warns. “With


a total daily volume of


$2.35trn (£1.8trn), as reported in the BIS 2016 data, many think of a liquid market. In fact, liquidity is much lower when you consider that this sum is spread across many different currency pairs. “According to BIS 2016 figures, the average available liquidity of the most traded cur- rency pair, dollar-euro, at the most fre- quently traded time was just $14.4m (£11.5m) per second across the entire FX market,” he adds. “Many asset managers underestimate the market impact they can already have with a mid-sized transaction.” One way to avoid a spike in transaction costs is to split larger volume trading deals into several smaller transactions. One example which illustrates how quickly the liquidity


not help liquidity levels. The decisive factor is who remains willing to take the trading risks onto their books and hold the counter position, the so-called internalisation pro- cess. Moreover, large sections of the currency market are still being traded over the coun- ter, Walde says. One consequence of banks retreating from the forex market is the emer- gence of new market participants. “Clients have to face the fact that the best prices might not necessarily come from a bank, but a non-bank liquidity provider,” New Chance FX’s Woolmer says.


Indeed, the top 20 forex trading firms in 2018 included four organisations which were not banks but they hold a combined market share of 14%, according to a FX sur- vey in 2018. High frequency FX trading firms such as XTX Markets or Virtu Financial pride them- selves for never being in the red and attrib- ute this to their advanced technology and risk management. A more fundamental rea- son for their strong performance might be that these non-bank liquidity providers hold their positions only for a short time and do not take the risks onto their own books. In a more turbulent market environment, calling these trading firms to find a counterpart for a FX position might not be worthwhile.


Issue 87 | October 2019 | portfolio institutional | 49


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