This is a relatively simple introduction to the sort of interest rate-based instruments available to both banks and corporates to enable them to manage interest rate risk. Other more exotic instruments include the following:
Swaptions. Swaptions give the holder the right but not the obligation to enter into a future defined swap agreement.
Interest rate swap futures. These are futures contracts in which the underlying instrument is the value of a specified interest rate swap contract.
Basis spread contracts. It is possible to trade futures contracts based on basis spreads,
for example on the spread between two benchmark rates such as those from an interbank market and those from government bonds.
Bond indices futures contracts. A relatively few standardized bond indices exist on which it is possible to trade futures contracts.
Caps and collars. It is possible to create a number of different positions based on combinations of call and put options.
Strips and synthetic zeroes. Investment banks can create a variety of synthetic products based on actual or notional coupon bonds. A government coupon bond can be used to create two securities. The first security entitles the holder to the coupon payments only, these securities are referred to as strips. The second makes no coupon payments but has the structure of a zero coupon bond.
Exotic Interest Rate Instruments
November 21st, 2009 No comments »Accounting Treatments Based on Intent
October 13th, 2009 No comments »The accounting method used affects reported earnings, book value and the value for Tier I capital as defined in the Basel Accord. Under US GAAP banks are permitted to use both the carried-at-cost and mark-to-market methods. From an economic value perspective this is clearly nonsense. The same security held in different accounts will be valued in different ways based on intent!
A bank could have holdings in an identical bond booked in three different accounts based on “intent”. If the intention is to hold the bond to maturity it is included at cost. If booked as “available- for-sale” the asset is held on the balance sheet at current market prices with unrealized gains or losses included in a reserve account within the equity account. If the bond is counted as a “trading security” the bond is marked to market with any gains or losses taken through the earnings statements. Finally, if the bank had raised finance itself by issuing its own bond with identical economic characteristics as the bond held as an asset this will be carried at cost.
The rigorous application of accounting standards results in book value numbers that are precise but have limited real meaning (although they are of consequence). Numbers that reflect economic value, by their very nature, should be approximate and based on estimates but would at least have a real significance.
Most banks have argued against compulsory mark-to-market accounting on the basis that it will result in more volatile reported earnings, book value and level of reported regulatory capital. So what? External auditors usually sign off a company’s accounts with a statement along the lines of “these financial statements give a true and fair view of the state of ABC Bank as of December 31 2006 and of the profit of ABC Bank for the year then ended”. If the economic reality is volatile then this should be reflected in financial statements and management should be prevented from trying to hide this fact through accounting obfuscation and obstruction.
The main criticism of those efforts that have been taken to make reported book value reflect economic value better is that they did not go far enough. The main area where there has been some progress in this direction has been in the treatment of traded securities. It is difficult, however, to see the sense of taking just selected parts of the interest rate-sensitive portion of a bank’s balance sheet and marking them to market, while ignoring the much larger proportion held in loans and also non-equity liabilities such as bonds that a bank has issued.
Active Currency Management
July 5th, 2009 No comments »Active currency management around a currency benchmark means the fund has given either the asset manager or a professional currency overlay manager the mandate to “trade” the currency around the currency hedging benchmark for the explicit purpose of adding alpha to the total return of the portfolio.
With active currency management, the emphasis should be on flexibility, both in terms of the availability of financial instruments one can use to add alpha and also in terms of the currency hedging benchmark. On the first of these, an active currency manager should have access to a broad spectrum of currency instruments in order to boost their chance of adding value. Similarly, their ability to add value is significantly increased by the adoption of a 50% or symmetrical currency hedging benchmark rather than by a 100% hedged or 100% unhedged benchmark.
RELATIVE RETURNS — ADDING ALPHA
July 4th, 2009 No comments »Asset managers who are focused on absolute returns when managing their currency risk tend to use strategies that are characterized by risk reduction, adopting a passive currency management approach in order to achieve this. By contrast, funds that are focused on relative returns tend to manage currency risk more actively. Their aim is after all to outperform an unhedged position, or in some cases the hedged benchmark, in other words to “add alpha”. In this, there is no “right” and “wrong”. It depends completely on the risk management style of the fund and what risk approach it takes towards both the underlying assets and also the embedded currency risk.
SELECTING THE CURRENCY HEDGING BENCHMARK
July 3rd, 2009 No comments »A crucial decision for portfolio managers who want to manage their currency risk, whether actively or passively, is the selection of their currency hedging benchmark. After all, when we are talking about managing currency risk, we are really talking about establishing whether or not there may be a need to hedge out that currency risk. Using a currency hedging benchmark is a more disciplined and rigorous way of managing currency risk than either not hedging or at the other extreme conducting all currency hedging on a discretionary and “gut feel” basis. There are four main currency hedging benchmarks used by institutional investors, which can be divided into:
100% hedged benchmark
100% unhedged benchmark
Partially hedged benchmark
Option hedged benchmark
Being 100% hedged is usually not the optimal strategy, apart from in exceptional cases. Equally, using a currency hedging benchmark of 100% unhedged would seem to defeat the purpose of managing currency risk, again apart from in exceptional cases. A further consideration is that many funds are not allowed to use options as they are viewed as a speculative financial instrument, ironically in the same way that some corporations are also not allowed to use them. This still leaves them however with the choice of three possible currency hedging benchmarks of 100% hedged, 100% unhedged or partially hedged. The primary instrument for such hedging would be the forward for passive currency management, though active currency managers would no doubt have greater flexibility, both in the currencies in which they can operate and the financial instruments they can use.
Currency hedging benchmarks of 0% or 100% are known as asymmetrical or polar benchmarks and have obvious limitations. With a polar benchmark, an active currency manager is able to take positions only in one direction. As a result, their ability to add value is also limited. For example, it is extremely difficult for a currency manager to be able to add value operating under an unhedged currency benchmark when foreign currencies are appreciating because the manager is generally unable to take on additional foreign currency exposure. The best the manager can do is to mimic the benchmark by holding the unhedged benchmark exposure and avoiding hedging. Similarly, when operating under a fully hedged benchmark, it is difficult for a manager to add value when foreign currencies are falling.
Adoption and use of benchmarks depends critically on the currency risk management style, for which the type of fund is clearly a key determinant. For instance, a pension fund manager may use a fully hedged or alternatively unhedged currency benchmark to either reduce risk on the one hand or minimize transaction costs on the other. Meanwhile, the active currency manager will seek a partially hedged benchmark, preferably 50%, to give them as much flexibility and room as possible with which to be able to add value. With such a symmetrical benchmark, active currency managers can take advantage of both bull and bear markets in their currencies. In the context of relative returns, it should therefore be of no surprise that there is good evidence to suggest that symmetrical benchmarks have consistently added more “alpha” than their asymmetrical counterparts.
Risk Reduction
July 2nd, 2009 No comments »The emphasis on risk reduction within a passive currency management style deals with the basic idea that the portfolio’s return in the base currency is equal to:
The return of foreign assets invested in + the return of the foreign currency
This is a simple, but hopefully effective way of expressing the view that there are two separate and distinct risks present within the decision to invest outside of the base currency. The motive of risk reduction is therefore to hedge to whatever extent decided upon the return of the foreign currency. From this basic premise, we can extrapolate the following:
Return (unhedged) = Return (asset) + Return (currency)
and
Return (hedged) = Return (asset) + Return (hedge currency)
The overall aim remains the same, and that is to reduce the overall risk of the portfolio, maximizing the total or absolute return in the process. In other words, it is to boost the portfolio’s Sharpe ratio, which is usually defined as the (annual) excess return as a proportion of the (annual) standard deviation or risk involved.
It should be noted from this formula however that some investors balk at the idea of hedging on the simplistic view that the hedge cost automatically reduces not just the hedged return of the asset but the asset’s total return in base currency terms. This is not necessarily the case. Actually, the converse can be argued, namely that the hedge reduces or eliminates any possible currency loss. Whether or not the investor hedges, there is the foreign currency return to be considered. That may add or detract from the asset return in foreign currency terms, and therefore may in turn boost or reduce the asset return in domestic currency terms. The hedging cost component will clearly depend on a number of variables, including the currency hedging benchmark and the financial instruments that can be used, but has clear parameters. The potential unhedged currency loss is theoretically limitless.
ABSOLUTE RETURNS — RISK REDUCTION
July 1st, 2009 No comments »Just as a corporation has to decide whether to run their Treasury operation as a profit or as a risk reduction centre, so a portfolio manager has to make the same kind of choice. While one can theoretically change one’s core approach to managing the portfolio at any time, it is usually better to make that choice right at the start. In the process, the portfolio manager should decide what style of portfolio management is to be adopted as regards the underlying investments, the desired return profile of the portfolio and also the style of currency management to be used. In the case of a portfolio manager who is focusing on absolute returns, the currency risk management style that is synonymous with this focuses on reducing the risk of the overall portfolio. This in turn usually means adopting a passive style of currency risk management.