INNOVATIVE APPROACH TO FOREIGN EXCHANGE RISK MANAGEMENT

Ramona Rupeika-Apoga Marina Kudinska

University of Latvia, Latvia

Abstract
Purpose of this research is by analysing different issues relating to the measurement and management of currency risk exposure to define an innovative approach to the management of foreign exchange risk. Design/methodology/approach During development of the paper the generally accepted qualitative and quantitative methods of economic research were used. Findings This research explores issues relating to the measuring and managing currency risk exposure, by examining the general concept of exposure and by designating the hedging strategy. The article explores firms and financial customers attitudes towards foreign exchange risk management during last years and future tendencies, by clarifying innovative approach to the management of foreign exchange risk. Research limitations/implications In the research was analysed only firms and financial customers attitudes towards foreign exchange risk management during last years. Practical implications - A practical implication of this research is the development of recommendation for new approach to the management of foreign exchange risk. Originality/value - Innovative approach to managing currency risk for an institutional fund is to establish its strategic approach to currency risk on the basis of fundamentals or on the basis of technical models in the form of a hedge ratio, representing the proportion of foreign currency exposure (i.e. foreign assets held) to be hedged. Keywords: Foreign exchange risk, risk measuring and exposure, hedging strategies Paper type Research paper

Introduction Exchange risk is simple in concept: a potential gain or loss that occurs as a result of an exchange rate change. For example, if an individual owns a share in Latvijas gaze, the Latvian company, he or she will lose if the value of the lats drops. Yet from this simple question several more arise. First, whose gain or loss? Clearly not just those of a subsidiary, for they may be offset by positions taken elsewhere in the firm. And not just gains or losses on current transactions, for the firm's value consists of anticipated future cash flows as well as currently contracted ones. What counts, modern finance tells us, is shareholder value; yet the impact of any given currency change on shareholder value is difficult to assess, so proxies have to be used. The academic evidence linking exchange rate changes to stock prices is weak. Moreover the shareholder who has a diversified portfolio may find that the negative effect of exchange rate changes on one firm is offset by gains in other firms; in other words, that exchange risk is diversifiable. If it is, than perhaps it's a non-risk. Finally, risk is not risk if it is anticipated. In most currencies there are futures or forward exchange contracts whose prices give firms an indication of where the market expects currencies to go. And these contracts offer the ability to lock in the anticipated change. So perhaps a better concept of exchange risk is unanticipated exchange rate changes. Hedging exchange risk is a complicated and difficult task. Varieties of hedging techniques are available, but before a firm uses them: 1) It must decide on which exposures to manage. 2) If foreign exchange risks are to be managed, they must first be quantified. 3) Once the firm has determined the exposure position it intends to manage, how should it manage that position? The object of this paper is foreign exchange risk management.

The purpose of this research is by analysing different issues relating to the measurement and management of currency risk exposure to define innovative approach to the management of foreign exchange risk. To achieve the purpose the following tasks were conducted: 1. Identifying foreign exchange risk and the necessity of risk management; 2. Analysis of the theoretical aspects of the measuring and managing foreign exchange exposure. 3. Designing a management strategy. 4. Clarifying corporate treasurers and financial customers attitudes towards foreign exchange risk management. 5. Development of recommendation for innovative approach to the management of foreign exchange risk. Chapter1 explores issues relating to the identification, measuring and managing currency risk exposure, by examining the general concept of exposure and by designating the management strategy. Chapter 2 explores firms and financial customers attitudes towards foreign exchange risk management during last years and future tendencies, by clarifying innovative approach to the management of foreign exchange risk. During development of the paper the generally accepted qualitative and quantitative methods of economic research were used. 1. What is exchange rate risk? 1.1. Necessity of foreign exchange exposure management Many firms refrain from active management of their foreign exchange exposure, even though they understand that exchange rate fluctuations can affect their earnings and value. They make this decision for a number of reasons: 1. Firms managers do not understand why and how to manage foreign exchange exposure, considering financial derivatives as speculative or they argue that such financial manipulations lie outside the firm's field of expertise. 2. Impossibility of measurement, considering currency exposure management too complex. 3. Considering that netting is enough a hedge for a firm, by covering imports or exports transactions, and foreign subsidiaries finance in local currencies. 4. Denying any exchange risk because it does all its business in home currency. All mentioned reasons could be counter argumented. In its broadest sense, foreign exchange risk refers to events abroad that affect the net income of a domestic firm. These could include, for example, a recession in a foreign market that adversely affects sales of domestic vendors to foreign buyers. Such a recession can affect not only the domestic vendor, but also the vendors suppliers who may operate only in the domestic economy. In this sense, foreign exchange risk can affect nearly all firms in a global economy. Taking into account that foreign exchange market activity became more global, with cross-border transactions representing 65% of trading activity in April 2010, while local transactions account for 35%, risk management question become more actual. The percentage share of the US dollar has continued its slow decline witnessed since the April 2001 survey, while the euro and the Japanese yen gained relative to April 2007. Among the 10 most actively traded currencies, the Australian and Canadian dollars both increased market share, while the pound sterling lost ground and the Swiss franc declined marginally. The market share of emerging market currencies increased, with the biggest gains for the Turkish lira and the Korean won.(BIS, 2010) The general concept of exposure refers to the degree to which a firm is affected by exchange rate changes. The impact can be measured in several ways, by using: - Accounting approach; Economic approach. The tree basic types of exposure are: Accounting exposure; Operating exposure; Economic

Transaction exposure exposure Accounting exposure (Translation) changes in the book value of balance sheet assets and liabilities and income statement items that are caused by an exchange rate change. Exchange rate change occurs impacts balance sheet assets and liabilities and income statement items that already exist. The measurement of accounting exposure is retrospective in nature as it based on activities that occurred in the past. Results: Paper only. Operating exposure changes in the amount of future operating cash flows (its future revenues and costs) caused by an exchange rate change. Exchange rate change occurs impacts: 1. Revenues and costs associated with future sales. 2. Any company whose revenues or costs are affected by currency changes, even it is a purely domestic corporation and has all its cash flaws denominated in home currency. The measurement of operating exposure is prospective in nature as it is based on future activities. Results: 1) Firms future competitive position; 2) Real. Transaction exposure- change in the value of outstanding foreign currency-denominated contracts that are caused by an exchange rate change. Exchange rate change occurs impacts: 1. Contractually-binding future foreign currency-denominated cash inflows and outflows. 2. Contracts already entered into, but to be settled at a later date. The measurement of transaction exposure is prospective in nature as it is based on future activities. Results: 1) Firms future competitive position. 2) Real. Economic exposure is based on the extent to which the value of the firm- as measured by the present value of its expected future cash flows- will change when exchange rate change. Economic exposure can be separated into two components: transaction exposure and operating exposure. Economic exposure can be separated into two components: transaction exposure and operating exposure. The firm faces operating exposure when it makes investments. These investments include new-product development, a distribution network, foreign supply contracts and so on. Transaction exposure arises later on and only if the firms commitments lead it to engage in foreign currency-denominated sales or purchases. 1.2. Steps in managing foreign exchange exposure An essential intergradient in any successful hedging program is for the firm to specify operational set of goals for those involved in exchange risk management. Failure to do so can lead to possibly conflicting and costly actions on the part of employees. Although many firms do have objectives, their goals are often sufficiently vague and simplistic as to provide little realistic guidance to managers. Often managers must challenge with dilemma of choosing between the goals of increased profits and reduced exchange losses. Moreover, reducing translation exposure could lead to an increase in transaction exposure and vice versa. What tradeoffs, if any, should a manager be willing to make between these two types of exposure? These and similar questions demonstrate the need for a coherent and effective strategy. The following elements are suggested for an effective exposure-management strategy: 1. Determine the types of exposure to be monitored. 2. Formulate corporate objectives and give guidance in resolving potential conflicts in objectives. 3. Ensure that these corporate objectives are consistent with maximising shareholder value and can be implemented. 4. Clearly specify who is responsible for which exposures, and detail the criteria by which each manager is to be judged. 5. Make explicit any constraints on the use of exposure-management techniques, such as limitations on entering into forward contracts. 6. Identify the channels by which exchange rate considerations are incorporated into operating decisions that will affect the firms exchange risk posture.

Develop a system for monitoring and evaluating exchange risk management activities.( Most of the elements are suggested in Evans T. and Folks W. (1979)) Objectives The usefulness of a particular hedging strategy depends on both acceptability and quality. Acceptability refers to approval by those in the organization who will implement the strategy, and quality refers to the ability to provide better decisions. To be acceptable, a hedging strategy must be consistent with top managements values and overall corporate objectives. In turn, these values and objectives are strongly motivated by managements belief about financial markets and how its performance will be evaluated. The quality, or value to the shareholders, of a particular hedging strategy, therefore, related to the congruence between those perceptions and the realities of the business environment. The most frequently occurring objectives, explicit and implicit, in management behaviour include the following: 1. Minimise translation exposure. This common goal necessitates a complete focus on protecting foreign currency-denominated assets and liabilities from changes in value due to exchange rate fluctuations. Given that translation and transaction exposures are not synonymous, reducing the former could cause an increase in the latter (and vice versa). 2. Minimise quarter-to-quarter (or year to year) earnings fluctuations owing to exchange rate changes. This goal requires a firm to consider both its translation exposure and its transaction exposure. 3. Minimise transaction exposure. This objective involves managing a subset of the firms true cash flow exposure. 4. Minimise economic exposure. To achieve this goal, a firm must ignore accounting earnings and concentrate on reducing cash flow fluctuations stemming from currency fluctuations. 5. Minimise foreign exchange risk management costs. This goal requires a firm to balance off the benefits of hedging with its costs. It also assumes risk neutrality. 6. Avoid surprises. This objective involves preventing large foreign exchange losses.(Zenoff, 1978) The most appropriate way to rank these objectives is on their consistency with the overarching goal of maximising shareholder value. To establish what hedging can do to further this goal, we must consider total risk. Total risk tends to adversely affect a firms value by leading to lower sales and higher costs. Consequently, actions taken by a firm that decrease its total risk will improve its sales and cost outlooks, thereby increasing its expected cash flows. Reducing total risk can also ensure that a firm will not run out of the cash to fund its planned investment program. Otherwise, potentially profitable investment opportunities may be passed up because of corporate reluctance to tap the financial markets when internally generated cash is insufficient. (Froot K, Scharfstein, Stein, 1994) There are other explanations for hedging as well, all of which relate to the idea that there is likely to be an inverse relation between total risk and shareholder value. For a good summary of these other rationales for corporate hedging, see Matthew Bishop, A Survey of Corporate Risk Management. Given these considerations, the view taken here is that the basic purpose of hedging is to reduce exchange risk, where exchange risk is defined as that element of cash-flow variability attributable to currency fluctuations. This is Objective 4. To the extent that earnings fluctuations or large losses can adversely affect the companys perceptions in the minds of potential investors, customers, employees, and so on, there may be reason to also pay attention to Objectives 2 and 6. However, despite these potential benefits, there are likely to be few, if any, advantages to devoting substantial resources to managing earnings fluctuations or accounting exposure more generally (Objectives 1 and 3). To begin, trying to manage accounting exposure is inconsistent with a large body of empirical evidence that investors have the uncanny ability to peer beyond the ephemeral and concentrate on the firms true cash flow generating ability. In addition, whereas hedging can dampen balance sheet gains and losses, operating earnings will also fluctuate in line with the combined and offsetting effects of currency changes and inflation. Further, hedging costs themselves will vary unpredictably from one period to the next, leading to unpredictable earnings changes. Thus, it is impossible for firms to protect themselves from earnings fluctuations due to exchange rate changes except in the very short run. In the next chapter the author considers firms and financial customers attitudes towards foreign exchange risk management during last years and future tendencies.

2. Innovative Approach to the Management of Foreign Exchange Risk 2.1. Corporate Treasurers Attitudes towards Foreign Exchange Risk Management From 1999 (by the introduction of the euro) most firms have adopted a more conservative/less dynamic approach to foreign exchange risk management. A number of the firms treasurers interviewed by the ESCB study group (The study of the Market Operations Committee (MOC) of the ESCB was conducted by a working group involving representatives from the ECB and from NCBs) reported that their firms senior management was increasingly risk-averse. They have clearly refocused on the firms core business, while their propensity for market risk has declined substantially. This general trend can be explained by three different factors. First, some industrial groups suffered significant losses in the foreign exchange market during the mid and early 1990s. Some of these cases have been widely publicised as they involved some misconduct by financial departments, while some others were handled more discreetly. In both cases past foreign exchange losses have encouraged more professional management of financial risks, with the result that the financial skills of the business community are much more developed today than they were ten years ago. Accompanying this has been a reduction in the appetite for risk and thus fewer transactions. Second, it seems that banks are in a better position to price the liquidity they offer as market makers. According to some firms treasurers, transaction spreads have not widened but banks have nevertheless convinced their customers to deal more often on an order basis, especially for large transactions. It seems that the ability or the willingness of some big firms to spoof or squeeze the market in less liquid currency pairs has been reduced over the years. Nevertheless, some banks reported occasional aggressive firms trading in some niche markets (especially in the Scandinavian currencies). Third, the ongoing changes in the regulatory and accounting environment (e.g. FAS 133 and IAS 39) have obliged firms to comply with more restrictive rules with regard to hedging. The international accounting standard IAS 39 and the US accounting standard FAS 133 (for US firms and European firms listed in the United States) oblige firms to document more precisely their hedging transactions, or conversely to mark-to-market their macro hedge positions (i.e. hedging deals not related to specific underlying transactions). These new accounting standards, while designed to prevent firms from taking excessive speculative positions (or at least to ensure that whatever risks companies do take are transparent to shareholders), might also lead them to leave some currency exposure unhedged. Indeed it is argued that for firms it would be too costly to put in place adequate systems and documentation. Furthermore, internal procedures might also be prohibitive (for example delays resulting from requirements for decisions on individual deals to be put before a companys Board of Directors). All in all, some firms may prefer to accept market risks rather than suffer the high costs and accounting risk, which, ironically, could result in increased volatility in the firms P/L accounts. These pessimistic views on the impact of FAS 133/ IAS 39 were not held unanimously, but were expressed by some interviewees. Firms are not a homogenous population and their attitude towards exchange risk is not uniform. Indeed, the function of the firms treasurer is not the same in all firms. While most have assigned the task of hedging or at least reducing the firms market exposure to the financial department, some view this as an autonomous profit centre whose objective is to boost the firms profitability through the active management of foreign exchange exposure and other market risks. However, only a minority of the treasurers interviewed headed up departments that acted as a proxy hedge fund or had a more limited own-trading activity. It therefore seems that the general trend towards a reduced appetite for risk is not in doubt. 2.2. Financial customers attitudes towards Foreign Exchange Risk Management. Global foreign exchange market turnover was 20% higher in April 2010 than in April 2007, with average daily turnover of $4.0 trillion compared to $3.3 trillion. The increase was driven by the 48% growth in turnover of spot transactions, which represent 37% of foreign exchange market turnover. Spot turnover rose to $1.5 trillion in April 2010 from $1.0 trillion in April 2007. The increase in turnover of other foreign exchange instruments was more modest at 7%, with average daily turnover of $2.5 trillion in April 2010. Turnover in outright forwards and currency swaps grew strongly. Turnover in foreign exchange swaps was flat relative to the previous 3 years, while trading in currency options decreased. As regards counterparties,

the higher global foreign exchange market turnover is associated with the increased trading activity of other financial institutions a category that includes non-reporting banks, hedge funds, pension funds, mutual funds, insurance companies and central banks, among others. Turnover by this category grew by 42%, increasing to $1.9 trillion in April 2010 from $1.3 trillion in April 2007. For the first time, activity of reporting dealers with other financial institutions surpassed inter-dealer transactions (ie transactions between reporting dealers) (BIS, 2010). Over the past few years, US hedge funds have become some of the largest users of Exchange Traded Funds (ETFs) they trade in size and often represent more than 30% of daily turnover on US exchanges. The opposite is true in Europe, where many large institutions are waiting for on-exchange liquidity to reach US levels. Critics argue that while the US ETF market has daily on-exchange turnover levels of 10-12% of total AUM, the European market remains static at a mere 1%. There are several factors that weigh against increased on-exchange liquidity in the European market in its current form, and most of them revolve around fragmentation. According to recent data from BlackRock, even though the European ETF market is only one third as large as the US market ($250 billion versus $850 billion in AUM), there are more ETF providers (28), more ETFs (829), and many more exchange listings in Europe (18). The net result is significant fragmentation of the European market, and no standout trading vehicles such as the SPDR S&P 500 ETF the worlds most liquid security and surely the ETF industrys defining product, to be expected. Multiple exchanges, multiple regulatory approaches (even under UCITS III), multiple currencies, domestic bias, differing tax regimes and captive distribution channels all make fragmentation inevitable. In contrast, the US is a vast and homogenous market. Retail investors account for a higher proportion of the ETF market in the US (50% of the investor base rather than 10% in Europe), and they are significantly more self-directed in their investment approach. More importantly, US hedge funds are large ETF users across several asset classes including equities and commodities, whereas historically they have not used European ETFs. This disparity results in a chicken-and-egg situation the market in Europe is not liquid enough to entice them, alongside the structural issues of there not being an active market in lending and shorting European ETFs. Bid/offer spreads are not competitive, and market makers arent used to putting up sizes on-exchange greater than 1 million. The result has been that European hedge funds have resorted to the OTC derivatives market for exposures that, in the US, they would achieve through ETFs. (Lytle, 2010) The liquidity, perceived brand value and high levels of infrastructure associated with the biggest hedge fund managers continue to attract investors. This has seen a flight of capital from the smallest firms, something that is shown by the decline in assets among the lower ranks in the Europe50. In 2008, for example, Adelphi Capital needed almost $2.3 billion to be in the 50th slot. A year later the amount Centaurus Capital needed for the final position fell to $1.5 billion. This year the final ranking belongs to RAB Capital with AUM of $1.08 billion. As firms have lost assets the years of expansion have given way to a prolonged period of downsizing. This trend has reached even the biggest firms as both Brevan Howard and Man Investments restructured costs last year. Though the hedge fund industry looks to have stabilised in 2010, most firms are refraining from expanding into new areas or adding staff.(The Europe 50, 2010) 2.3 Currency overlay Since mid-2007, currency markets have become more volatile. Generally, risk contribution from unhedged currency exposures will be higher than it has been in the past. For this reason, currency risk management may be more of a priority than ever. That is why as firms as financial institutions have tended to take a more proactive approach to the management of foreign exchange positions in recent years by separately identifying and managing currency exposures, a process known as currency overlay. This partly reflects a trend towards greater diversification of underlying asset positions across international markets (some market participants have suggested that the introduction of the euro has led some fund managers to further diversify asset holdings outside the euro area). It also reflects a greater recognition of the impact of currency exposures on base currency returns insofar as funds are required to report performance more frequently and in greater detail, and a more widespread acceptance of the intellectual case for managing currency risk. This is essentially because unmanaged currency exposure has a zero expected return in the long term but adds volatility to reported returns in the meantime. Currency overlay managers also argue that foreign exchange is in effect an asset class, which, if actively managed, can help reduce risk through diversification benefits and yield positive returns. Lower returns in equity markets over the past five years are said to have encouraged

equity fund managers to focus more on currency returns, which they might previously have considered too small to be of interest. However, many cross-border funds do not seek to manage currency risk. In some cases this may be due to the nature of the fund for example, investors in a retail fund advertised as holding foreign equities might be considered to expect and even desire the currency risk on the asset position rather than have it hedged away. Higher hedge ratios are also associated with a higher volume of transactions, which some funds find undesirable. A decision to effectively disregard currency exposure may be due to regret risk: i.e. even if the intellectual case for hedging currency risk is accepted, the decision to start doing so entails the risk that, in retrospect, it would have been better to maintain an unhedged position. In some countries regulation may also be a constraint. One approach to managing currency risk for an institutional fund is to establish its strategic approach to currency risk in the form of a hedge ratio representing the proportion of foreign currency exposure (i.e. foreign assets held) to be hedged. This hedge ratio may be derived by a mean-variance analysis that calculates, on the basis of certain assumptions and given the fund managers risk tolerance, an optimum level of currency exposure, taking advantage of the diversification benefits offered by currency risk. Alternatively, the hedge ratio may be determined in a less complicated way: e.g. a common hedge ratio is 50%. Some funds choose to hedge 100% of their currency risk, although higher hedge ratios will generate more transactions, which some fund managers dislike. A currency overlay is used to separate currency risk from the risk of the underlying asset classes, centralise the currency risks in the underlying portfolio(s) and manage them effectively and efficiently. Currency risk can be managed either passively or actively: Passive currency overlay or hedging programs systematically remove a pre-determined proportion of currency risk (e.g., 50%, 75% or 100%). Active currency overlay or active hedging programs are designed to manage currency risk in order to add value to the overall portfolio. The active currency hedge manager actively increases the hedge ratio applied to currencies that are expected to depreciate, thus protecting the investor from exposure to depreciating foreign currencies; and actively reduces the hedge ratio applied to currencies that are expected to appreciate, allowing the investor to benefit from exposure to those currencies. Currency overlay may be performed by a separate team in the fund management company, which is common practice in the larger institutional funds, or by independent overlay providers (several large asset management groups offer such services). Currency overlay managers may also actively manage foreign exchange risk, taking foreign exchange positions away from the strategic currency exposure benchmark, in search of additional return. Use of active currency management is believed to have grown rapidly in recent years. The number of firms offering a currency overlay service has increased, although some of the interviewed market participants felt that new business was now increasingly going to the larger, more established providers. One analyst suggested that the number of providers has increased from around 12 in1995 to nearer 40 in 2000 (James, 2001). The growth of active currency management is said to have been driven in part by empirical research from actuarial consultants, which has concluded that currency overlay has in practice generated positive returns. (Baldridge, Meath ,Mye, 2000). In explaining these results, the proponents of active currency overlay often argue that the foreign exchange market is inefficient owing to, for example, the presence in the market of allegedly non-profit maximising players, such as firms, institutional funds themselves (through their hedging activities) and central banks. Active currency overlay managers employ a variety of different model types. Indeed, they will often use a combination of different models where research suggests that the correlation between the returns of the different model types is low (ECB, 2003). This combined approach allows the currency manager to take positions and allocate active risk towards currency pairs where the manager has high conviction views. An active hedging programme is simultaneously trying to manage risk and enhance return. In contrast, in the combined approach, the currency manager implements a passive hedge to remove a fixed percentage of the underlying portfolios currency risk (usually a 100% hedge is implemented). Then, to enhance returns, the currency manager implements a pure alpha currency programme. The pure alpha currency programme can take long and short positions on any currency, and its objective is to generate absolute returns so its performance is not measured against a

benchmark, but rather is measured against zero. In 1 table could see the comparison of pros and cons of different management approaches. Table 1. Comparison: Passive vs. Active vs. Passive + Alpha combined approach (FX Overlay)
Passive Hedge Active Hedge Passive Hedge + Currency Alpha Program

Objective

Risk reduction

Risk Management: replaces random Return generation: risk with managed risk Separates currency risk from the underlying portfolio and generates excess return by actively taking currency exposures. Client receives partially hedged returns on the underlying portfolio. The hedge ratio is increased on currencies the currency manager expects to depreciate, to protect the investor, and the hedge ratio is reduced on currencies the currency manager expects to appreciate, to allow the investor to participate in foreign currency appreciation. The currency manager cannot increase exposure to any currency, beyond what exists in the underlying portfolio. But the worst case is that the managers forecasts are incorrect and appreciating currencies are overhedged, whilst depreciating currencies are underhedged. In that scenario, the active hedging programme will generate a negative return, and total portfolio return will be inferior to leaving the portfolio completely unhedged. Client receives the local market returns (for a 100% hedged portfolio), less hedging costs (transaction costs, manager fees and interest rate differential between risk currencies and base currency), plus the returns earned on the currency alpha programme. Removes all currency risk from the underlying portfolio (if 100% hedged), but there is a risk that the currency alpha programme may produce negative returns.

Return

Client receives local market returns (for a 100% hedged portfolio) less the cost of the hedging programme (transaction costs, manager fees and interest rate differential between risk currencies and base currency).

Risk

Removes all currency risk (if hedged 100%), but the investor forgoes the possibility of participating in any appreciation of foreign currencies.

Number of currencies on which the manager can take positions

Limited to the number of Limited to the number of currencies Can be unlimited, or currencies to which the underlying to which the underlying portfolio limited according to portfolio has exposure. has exposure. constraints set by the investor (e.g., developed market currencies only, or liquid currencies only). Any positive fixed percentage. E.g., a portfolio can be 50% hedged, 75% hedged or 100% hedged. Any positive fixed percentage. E.g., the benchmark hedge ratio can be set at 0% hedged, 50% hedged, 75% hedged or 100% hedged. The currency manager then varies the actual hedge ratio around the benchmark. The passive hedge programme is usually benchmarked at a 100% hedge ratio. The currency alpha programme is an absolute return programme and is generally

Benchmark

benchmarked against zero if unfunded, or a cash interest rate if funded. Minimum hedge ratio for any given currency The minimum hedge ratio is generally set equal to the benchmark hedge ratio less some small tolerance level. E.g., 95% hedged 5%, so the minimum threshold for the passive hedge = 90%. If it falls below this, the hedge must be increased. At least 0%. The least the manager can do is to leave a currency exposure from the underlying portfolio unhedged. The manager cannot increase exposure to a currency beyond what exists in the underlying portfolio. And the manager cannot create exposure to currencies which the underlying to which the portfolio does not have exposure. At most 100%. The most the manager can do is completely hedge currency exposure from the underlying portfolio. The manager cannot decrease exposure to a currency beyond what already exists in the underlying portfolio. And the manager cannot take short positions on currencies to which the underlying portfolio does not have exposure. Client determined. The maximum short position on any currency can be constrained by the investor.

Maximum hedge ratio for any given currency

The maximum hedge ratio is generally set equal to the benchmark hedge ratio plus some small tolerance level. E.g., 95% hedged + 5%, so the maximum threshold for the passive hedge = 100%. If it increases above this level, the hedge must be decreased.

Client determined. The maximum long position on any currency can be constrained by the investor.

Funded or Unfunded

Unfunded. Cash is left invested in the underlying portfolio of equities, bonds, etc.

Unfunded. Cash is left invested in Unfunded or funded. Cash the underlying portfolio of equities, can be left invested in the bonds, etc. underlying portfolio of equities, bonds, etc. Or a small amount of cash can be invested into a currency alpha fund. Cashflows are generated only at the maturity of FX forward contracts generally monthly or quarterly. Positive cashflows are contributed back to the investors portfolio. Negative cashflows must be met from the investors cash reserves or by liquidating other investments. Cashflows are generated only at the maturity of FX forward contracts generally monthly or quarterly. Positive cashflows are contributed back to the investors portfolio. Negative cashflows must be met from the investors cash reserves or by liquidating other investments. It is possible to net cashflows from the passive hedging programme and the currency alpha programme against each other.

Cashflows generated by the programme

Cashflows are generated only at the maturity of FX forward contracts generally monthly or quarterly. Positive cashflows are contributed back to the investors portfolio. Negative cashflows must be met from the investors cash reserves or by liquidating other investments.

Both positive and negative cashflows generated by high hedge When foreign currencies ratios can be significant. appreciate, the underlying portfolio will produce a positive return and the passive hedging programme will generate a negative return. Net return at portfolio level will at least partially offset each other, but the negative cashflows on the currency hedging programme still need to be met, despite the fact that the

currency gains on the underlying portfolio may not have been realised.

But is there any economic justification for a "do nothing" strategy? However, many cross-border funds do not seek to manage currency risk. In some cases this may be due to the nature of the fund for example, investors in a retail fund advertised as holding foreign equities might be considered to expect and even desire the currency risk on the asset position rather than have it hedged away. Higher hedge ratios are also associated with a higher volume of transactions, which some funds find undesirable. A decision to effectively disregard currency exposure may be due to regret risk: i.e. even if the intellectual case for hedging currency risk is accepted, the decision to start doing so entails the risk that, in retrospect, it would have been better to maintain an unhedged position. In some countries regulation may also be a constraint. Some of reasons not to hedge foreign exchange exposure are: The investor has a very long time horizon and is insensitive to short and medium term returns volatility. The investor has a well-informed and strong conviction that the foreign currencies to which he has exposure will appreciate versus his base currency. The cost of implementing a currency hedge (transaction costs + interest rate differential between currencies) may be too expensive versus the expected risk contribution from unhedged currency risk. For example, this is often the case where the investors base currency carries a relatively low interest rate, like the Japanese Yen. The risk contribution from unhedged currency exposure is relatively low. The investor is unable to meet potential negative cashflows which may result from the currency hedge. Conclusions: The first step in management of foreign exchange risk is to acknowledge that such risk does exist and that managing it is in the interest of the firm and its shareholders. The next step, however, is much more difficult: the identification of the nature and magnitude of foreign exchange exposure. In other words, identifying what is at risk, and in what way. Firms are not a homogenous population and their attitude towards exchange risk is not uniform. While most have assigned the task of hedging or at least reducing the firms market exposure to the financial department, some view this as an autonomous profit centre whose objective is to boost the firms profitability through the active management of foreign exchange exposure and other market risks. Many firms refrain from active management of their foreign exchange exposure, even though they understand that exchange rate fluctuations can affect their earnings and value. Recently, most firms have adopted a more conservative approach to foreign exchange risk management, sometimes motivated by poor results of active foreign exchange management (some big manufacturing firms suffered significant losses in the foreign exchange market during the 1990s) and further encouraged by ongoing changes in the regulatory and accounting environment (namely FAS 133 and IAS 39). At the same time the pressure to monitor and manage foreign currency risks has led many firms to develop sophisticated computer- based systems to keep track of their foreign exchange exposure and aid in managing that exposure. Management of foreign exchange risk centres on the concept of currency overlay or hedging. A currency overlay is used to separate currency risk from the risk of the underlying asset classes, centralise the currency risks in the underlying portfolio(s) and manage them effectively and efficiently. Currency risk can be managed either passively or actively. Innovative approach to managing currency risk is to use combined approach (from passive to active) of risk management that offered by different investment managements companies by finding the most proper model for unique firm purposes.

It is preferable to establish its strategic approach to currency risk in the form of a hedge ratio, representing the proportion of foreign currency exposure (i.e. foreign assets held) to be hedged. This hedge ratio may be derived by a mean-variance analysis that calculates, on the basis of certain assumptions and given the fund managers risk tolerance, an optimum level of currency exposure, taking advantage of the diversification benefits offered by currency risk. References: Asset Management Overlay (2010), available at: http://www.fxoverlay.com/home/(accessed 9 September 2010) Baldridge, Meath and Myer (May 2000). Capturing Alpha through Active Currency Overlay // European Central Bank. Bishop M. (1996). A Survey of Corporate Risk Management// The Economist, February 10, special section. Evans T., Folks W. (1979). Defining Objectives for Exposure Management// Business International Money Report, February 2. Froot K., Scharfstein D. and Stein J.(1994). A Framework for Risk Management// Harvard Business Review, November. Hedge Fund Report Card (2010), available at: http://www.hedgefundintelligence.com/(accessed 13 September 2010) James J. (2001). Investment & Pensions Europe// IPE Magazine, September. Lytle M. Hedge Funds and the European ETF Market (2010), available at: http://www.thehedgefundjournal.com/magazine/201009/commentary/hedge-funds-and-the-europeanetf-market.php (accessed 10 September 2010)

Study of the Market Operations Committee (MOC) of the ESCB// European Central Bank, 2003.
The Europe 50.The hedge fund journal(2010), available at: http://www.thehedgefundjournal.com/magazine/201009/research/the-europe-50-2010-.php(accessed 10 September 2010) The Prudential Regulation and Management of Foreign Exchange Risk// IMF Working Paper: Monetary and Exchange Affairs Department, International Monetary Fund, 1998. Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2010, Preliminary global results// Bank for International Settlements, Press & Communications CH-4002 Basel, Switzerland, September 2010. Zenoff D. (1978). Applying management principles to Foreign Exchange Exposure// Euromoney, September.
Biographic notes: Ramona Rupeika-Apoga is an Associated Professor at University of Latvia. The main research areas are: Global Finance, Foreign Exchange Market and Banking Economics. Marina Kudinska is a Docent at University of Latvia. The main research areas are: Banking Operations, Bank Risk Management and Bank Analyses.