Financial analysts » risk

Tracking Error

admin — Sun, 04 Jul 2010 08:35:50 +0000

Just as corporations have to deal with “forecasting error” in terms of the deviation of forecast exchange rates relative to the actual future rate, so investors have to deal with “tracking error” within their portfolios, which is the return of the portfolio relative to the investment benchmark index being used. Within this, there is “expected” and “realized” tracking error. Expected tracking error is as the name suggests determined before the fact — ex ante — whereas the realized tracking error is determined after the fact.
Determining the relevance of tracking error is also a function of comparing the portfolio’s hedging strategy with a random strategy, which creates hedge/don’t hedge signals with equal probability on a regular basis. Using polar benchmarks — i.e. 0% or 100% hedged — the equal probability of the outcome of the random strategy suggests that hedge deviations will be zero in half the cases and 100% in half the cases. However, with a partially hedged currency benchmark, the deviations will vary in direct proportion to the ratio of the benchmark. For instance, for a symmetrical or 50% hedged currency benchmark, the deviations will be 50% from each side of the benchmark.
From this, we can gather two things, firstly that the tracking error — or the deviation — is a function of the hedged ratio used for benchmarking and secondly that the tracking error for a partially hedged benchmark should be less than that for a polar benchmark. Indeed, generally, the tracking error for a symmetrical or 50% currency hedging benchmark should be around 70% of the tracking error using polar benchmarks. Expressed differently, the tracking error of a polar benchmark should be 1.41 (square root of 2) times higher than that of a 50% hedged benchmark. The advantage of a symmetrical or 50% currency hedged benchmark for a portfolio manager is that it reduces the tracking error of the portfolio and also enables them to participate in both bull and bear markets compared to the polar benchmark where the participation is limited to either/or.
Tracking error can be further reduced by a technique known as “matched hedging”, which increases or decreases the hedge ratio relative to the change in asset allocation. Historically, the act of asset allocation itself within fixed income portfolios has been a major and seemingly unavoidable factor in increasing a portfolio’s tracking error. Matched hedging can reduce though clearly not eliminate this.
Tracking error can also occur under passive currency management. This is because in order to implement a passive currency hedging programme a portfolio manager still has to adjust the amount of the currency hedge relative to the value of the underlying as it changes on a regular basis — i.e. once a month. In reality, many portfolio managers don’t bother to do this. As a result, the residual that is left over- or under-hedged contributes to the tracking error. In this, the portfolio manager has to balance the transaction costs of re-balancing the currency hedges against the negative effect on tracking error.

Adding “Alpha”

admin — Fri, 03 Jul 2009 08:34:47 +0000

The motive of risk reduction is primarily defensive, in that it seeks to defend or maintain the portfolio’s return within a given tolerance of overall risk. That for adding “alpha” on the other hand is quite different, in so much as “alpha” refers to the excess return generated by an active currency manager relative to a passive hedging programme.
Economic theory suggests that the long-term return of a currency is zero, so how can an active currency manager add value or “alpha”? There appear to be two aspects to this question. Firstly, currency markets are dominated by short-term movement. Thus, while their long-term return may be zero, their short-term returns (and losses!) may be significant. Secondly, it should be remembered that the same theory that suggested there were fundamental equilibrium levels for currencies also suggests that their long-term returns are zero. While not rejecting such a theory outright, it should surely be treated with some care, put in this context.
Indeed, there is a fine — and increasing — body of academic work that suggests that contrary to theory, managing currency risk can indeed add “alpha”. Among these, I will draw out several notable examples. Firstly, while formulating his “Universal Hedging Policy” in 1989, Fisher Black suggested that currency was, contrary to theory, not a zero sum game and investors could indeed increase their returns by holding currency inventories. Needless to say, this contradicted the widely held view that currencies could not provide added value because currency markets were perfectly efficient. A relatively short time after that, Mark Kritzman put forward the view that active currency managers could take advantage of the apparent serial correlation in currency returns. Subsequent research by Taylor (1990) and Silber (1994) targeted market trends as being behind persistent positive returns from currency managers.
Two further research reports that should be mentioned are those by Strange (1998, updated 2001) and The Frank Russell Company (2000). In the first case, the survey by Brian Strange, as published in Pensions and Investment (15/6/98), entitled “Do Currency Managers Add Value?” stated that of the 152 individual currency overlay programmes managed by 11 firms, these produced an average of 1.9% per year over a 10-year review period from 1988 to 1998, while simultaneously reducing the risk of the portfolio. In other words, not only did currency managers consistently add value, but their action of seeking to manage currency risk also helped lower the overall risk profile of the portfolio, thus boosting the Sharpe ratio from both sides! The second example is that of the Frank Russell study of May 2000 entitled “Capturing Alpha through Active Currency Overlay”, which analysed the historical performance of currency overlay mandates and confirmed the view that managing currency risk does indeed add value or “alpha”.
As noted above, a host of empirical studies have proven conclusively that active currency management can indeed boost the portfolio’s return, both on an absolute basis and in this context relative to not hedging, in contrast to classical exchange rate theory. In line with this, a number of studies have been published suggesting clear market inefficiencies, which might therefore be taken advantage of by active currency managers. For instance, the 1993 study by Kritzman, suggesting that the discount/premium of the currency forward contract “systematically and significantly overestimated the subsequent change in the spot rate”. Kritzman also introduced the concept of so-called “bilateral asymmetry”, referring to a bias by risk-averse investors for the perceived predictable returns of the interest rate differential as opposed to the unpredictable returns of the currency. Work by Choie (1993) supported these findings. Overall, a body of informed opinion has developed, supportive of the view that active currency management can add value.
After finally admitting that currency markets may offer profit potential, whether over the short or long term, academic theorists have suggested that such profit opportunities may exist in currency markets because there are some currency market participants that are not solely or even mainly motivated by profit. Classical theory suggests rational currency market participants are solely profit-seeking and moreover offset each other, with the result that any outstanding profit opportunities are instantly arbitraged away. Thus, from this, they seek to explain the existence of sustained profit opportunities within currency markets by suggesting that non-profit-seeking currency market participants such as central banks, tourists and national or corporate Treasuries effectively distort pricing. To me, such a view appears more reflective of the guesswork of someone who does not actually know the answer but is afraid to own up. Currency markets generate profits because it is the theory that they should not that is wrong rather than the currency market itself.
Active currency management can add value because there is value to be had in currency markets, plain and simple. Within this, an active currency manager will clearly favour the most flexibility possible to add that value, both in terms of the currency benchmark that they have to operate under and the currencies and financial instruments with which they are allowed to trade. For the active currency manager, the foreign currency return is not just a matter of currency translation of the underlying asset, but also of the excess return or alpha that the currency manager is able to add. The alpha an active currency manager generates is usually measured against an unhedged position. However, probably a truer idea of the alpha the active currency manager generates would come from comparing their returns to those of a passive currency management strategy of maintaining the benchmark hedge ratio. Historically, the typical mandate has allowed managers to vary the hedge ratio between 0 and 100% regardless of the benchmark.

HEDGING — MANAGEMENT RELUCTANCE AND INTERNAL METHODS

admin — Thu, 02 Jul 2009 08:34:45 +0000

Having looked in detail at the issue of managing currency risk, we should now be looking at the specifics of how to hedge that risk. Before we do that, we first have to examine the issue of management reluctance to hedge a risk many see as merely an operational hazard of international investment. Some may dismiss this section, either because it is irrelevant to them or because they view any such approach as inappropriate. While I too share the view that currency risk should be managed, such management reluctance should not be ignored, but instead should be understood and thereafter combated. Three key reasons for this reluctance which come up time and again are the following:
Management does not understand active currency management methods
Management thinks currency risk cannot be measured accurately
Management sees active currency management as outside of core business
Some of these points are reasonable. Currency forwards and options may well be outside the field of expertise of a corporation’s management, and will certainly be outside the core business operations. Many managements consider such financial instruments as speculative. However, it is the job of Treasury to explain that not managing currency risk actively leaves the corporation vulnerable to major exchange rate movements, which can cause substantial swings in the company’s value. Using forwards or options may indeed be speculative, depending on what they are used for. However, not hedging currency risk may be even more speculative. Active currency management is a necessary byproduct of a corporation’s overseas investments and operations. Again, it is the job of the Treasury to educate the management and ultimately the board on the need for active currency management, not least to maintain and ensure the corporation’s equity market value. A corporation may not be able to boost shareholder value significantly through active currency risk management, but it can certainly damage it by not managing currency risk.
When management says it is difficult to measure currency risk it is correct, but that does not mean such risk cannot be quantified. Imprecision is not an excuse for indecision in the corporation’s underlying business. Neither should it be tolerated with regard to currency risk management.
Even if a management is willing to consider currency hedging, there are ways of “natural” or internal hedging that it may consider first, such as:
Netting (debt, receivables and payables are netted out between group companies)
Matching (intragroup foreign currency inflows and outflows)
Leading and lagging (adjustment of credit terms before and after due date)
Price adjustment (raising/lowering selling prices to counter exchange rate moves)
Invoicing in foreign currency (this cuts out transactional exposure)
Asset/liability management (for balance sheet, income or cash flow exposure)
Netting involves the settling of intragroup debt, receivables and payables for the net amount. The simplest form of this is bilateral netting between two affiliates.
Matching is similar but can be applied both to intragroup and third-party flows. Here, a corporation “matches” its foreign currency inflows and outflows with respect to amount and timing.
Leading and lagging refer to adjusting credit terms between group companies, where “leading” means paying an obligation in advance of the due date and “lagging” means after the due date. This is a tactic aimed at capturing expected currency appreciation or depreciation. Price adjustment involves increasing selling prices to counter exchange rate moves. Invoicing in foreign currency reduces transaction risk relating specifically to exports and imports.
Asset and liability management can be used to manage the balance sheet, income statement or cash flow exposure. Corporations can adopt either an active or a passive approach to asset and liability management, depending on their currency and interest rate risk management policy.
Finally one can hedge internally by increasing corporate gearing. Leverage shields corporations from taxes because interest is tax-deductible whereas dividends are not. However, the extent to which one can increase gearing or leverage is limited by costs. That said, if currency hedging reduces taxes, shareholders benefit.
For practical purposes, three questions capture the extent of a corporation’s currency risk:
1. How quickly can a corporation adjust prices to offset exchange rate impact on profit margins?
2. How quickly can a corporation adjust sources for inputs and markets for outputs?
3. To what extent do exchange rate moves have an impact on the value of assets?
Within a corporation, it is usually the case that those who can come up with the best answers to these questions are directly involved in such tasks as purchasing and production. Thus, finance executives who focus exclusively on the credit and currency markets can in fact miss the real essence of a corporation’s currency risk. Furthermore, the exact answers to these questions need to be known not only by the oversight or risk committee, but preferably by the CEO as well. If they don’t, they effectively don’t know both the value and the exposure of the corporation.