Currency overlay by Neil Record

By Neil Record

Foreign money overlay has grown in parallel with the foreign diversification of institutional funding portfolios. foreign money overlay mandates now hide round $100bn in resources, and 18 years because the first overlay mandate, foreign money overlay has now come of age.

foreign money Overlay seems to be in any respect the elements that make up an overlay mandate and the selections and research best as much as it. it's written in an obtainable type, designed for the asset supervisor, pension fund supervisor, funding advisor, trustee or scholar.

a few of the author's analyses commence from first ideas. recommendations vital to the case are absolutely defined ahead of applying them, permitting the reader with out past wisdom of the topic to workout self sufficient judgement. the writer makes extensive use of self-contained 'boxes' to demonstrate and clarify specific parts or suggestions.

foreign money Overlay covers, among different themes:

* The theoretical case for removing forex possibility in foreign portfolios * The interaction among asset returns and forex returns, and the impact of this on hedging judgements * Benchmarks - their building and strategic position * Least-cost passive overlay * The constitution of the foreign money marketplace, and its 'inefficiencies' * lively overlay types * lively overlay either limited and unrestricted (currency alpha)

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This is because we have defined currency surprise as: Currency surprise % = (Spot ratet − Forward ratet−1 )/Spot ratet−1 not Currency surprise % = (Spot ratet − Forward ratet−1 )/Forward ratet−1 The Problem 19 In the latter case, all the inverse currency surprises would be identical as long as we converted the currency surprise % to logs. The 20-year volatility averages mask very significant variations in the volatility of currencies. Popular economic history will remind most readers that there are occasional currency ‘crises’, in which one or more currencies suffer a sharp movement versus others.

The answer to this is dependent on the jurisdiction, and the practices of the profession responsible for pension fund valuation – actuaries. In the UK and the US, until fairly recently, many pension fund asset valuations were made on the basis of ‘discounted cash flow’. Discounted cash flow valuation ignores market values of otherwise perfectly marketable securities, and instead values them on the basis of a valuation model. As this applies to equities, the model runs something like this: r Step 1 r Step 2 r Step 3 r Step 4 Establish the current dividend yield of the security or index Project the dividend out into the future using a dividend growth assumption Calculate the stream of dividend cash flows arising from these assumptions Discount the stream of cash flows to a present value (PV) at an arbitrary discount rate r Step 5 Call this PV the valuation of the assets There are numerous objections to this valuation methodology, not least that the valuation so devised will not be the asset sale value.

3 Sensitivity Forward contracts are a ‘straight line’ hedge – that is, if the principal value of the contracts equals the asset value, then it will fully eliminate foreign currency risks. 1 apply to forward contracts. However, forward contracts are very cheap and easy to adjust in size, they are ideal for hedging a changing asset value. They are also easy to value (using the forward currency market to mark them to market), and their change in value is dominated by the movements in the spot market rather than changing interest rate differentials.

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