There, in black and white
NB Bulletin Vol. 12 N. 10, July 2009
The high volatility of the Canadian dollar in recent years relative to the major foreign currencies has had a strong impact on returns on foreign assets for Canadian investors. The current economic environment coupled with the effect of currency fluctuations on pension fund performance is encouraging investors to consider hedging foreign assets against currency risk.
Why hedge against currency fluctuations?
Consider a diversified portfolio of U.S. equities, for example. Despite security diversification within the portfolio, the assets are all exposed to the U.S. dollar. This creates a concentration of risk and performance becomes sensitive to U.S. currency volatility.
Foreign currency risk generally becomes a concern when more than 15% of the fund's assets are exposed to foreign currency. Many pension committees are facing this issue since, on average, 20% to 40% of pension fund assets are exposed to foreign currencies. In addition, in the event where the value of the Canadian dollar appreciates, returns on foreign assets will be negatively affected.
It is also important to point out that pension plan commitments are in Canadian dollars. Foreign currencies thus introduce an additional liability risk component that pension committees must be made aware of.
Forward contracts are the financial instruments most commonly used to hedge against foreign currency risk. Forward contracts can be adjusted to meet the specific needs of a pension fund depending on factors such as the type and amount of currency to be hedged and the duration of the contract. However, these financial instruments involve counterparty risk, that is, the risk that the other party to the contract becomes insolvent. Different control mechanisms can be used to monitor and minimize counterparty risk.
Specific elements to consider with currency hedging
Currencies to be hedged
There are many foreign currencies, so the first step is to determine which currencies should be hedged. Currencies typically found in pension funds are the U.S. dollar, the Euro, the Yen and the Pound Sterling. The choice of which currency to hedge depends on the pension committee's risk tolerance. If risk tolerance is low, it is best to hedge against all main currencies. If risk tolerance is higher, then it may be appropriate to hedge only against the U.S. dollar. Generally, the risk associated with fluctuations in a particular currency becomes a major concern when exposure to that currency exceeds 10% of fund assets. This is the case with the U.S. dollar for most pension funds.
The hedge ratio is the proportion of the assets exposed to a foreign currency that is to be hedged. The hedge ratio can range from 0% (unhedged) to 100% (complete hedge). In setting the desired ratio, we must keep in mind that moderate exposure to a currency helps to diversify a portfolio. A complete hedge reduces the diversification, in addition to exposing the pension fund to the risk that the hedge exceeds the value of the underlying foreign assets if their value decreases due to negative returns. A partial hedge eliminates this possibility. A 50% hedge ratio will reduce the risk of currency fluctuations and at the same time, maintain the benefits of diversification.
Currency hedging can be managed with different approaches. Pure passive management or passive management with dynamic hedging are the management approaches best suited to pension funds. With pure passive management, the hedge ratio remains constant. In passive management with dynamic hedging, the hedge ratio is adjusted depending on market exchange rates. The underlying principle of this approach is that exchange rates should normally converge toward an equilibrium value determined by economic indicators such as purchasing power parity. However, exchange rates can diverge from equilibrium value, and this approach aims to take advantage of such deviations in exchange rates by adjusting the hedge ratio accordingly.
Timing of the implementation
Another key element to be considered is the timing of the implementation of the strategy. This is not a tactical issue but a matter of establishing a disciplined and rigorous process so the hedge will be introduced at the right time. Passive management with dynamic hedging promotes implementation, as it allows currency hedging with a lower hedge ratio if market conditions are not optimal.
It is generally preferable to determine first if a manager within the pension fund's structure has the required expertise to trade foreign currency forwards. If the chosen hedging approach is more complex, currency management may be entrusted to a specialized manager. Costs for such management vary depending on its complexity. It is crucial not to underestimate the complexity of the tasks involved in currency hedging management, particularly settlement of gains and losses, forward contract renewals and counterparty risk monitoring.
To conclude, foreign currency exposure is a risk that pension committees must be made aware of and currency hedging can be an appropriate component of portfolio risk management. In addition, current exchange rates should not dissuade committees from considering currency hedging. All aspects must be analyzed and thoroughly understood in order to determine the appropriate currency management approach.
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