Currency Overlay: A Practical Guide (2nd Edition)
Currency Overlay: A Practical Guide (2nd Edition)
Hai Xin
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The much-elevated volatility level of the foreign exchange spot prices and a near-seizure of the foreign exchange forward and swap market at the height of the global financial crisis seem a distant memory for some, but many investors may be feeling distinctly uneasy about the currency risk in their global investment portfolios. In 2010, within a matter of a few months, we saw a euro scare, immediately followed by a US dollar scare. And, not quite on the fringe of the global currency market, there were ominous talks about “currency wars”. Looking ahead, many investors may be pondering on not only “known unknowns” but also, increasingly, “unknown unknowns” - “interesting times”, Confucius would have wisecracked.
The Second Edition of Currency Overlay: A Practical Guide does not attempt to disentangle the dense web of political, economic and sentimental factors that may drive the future moves of world’s currencies. Instead, it continues to emphasise the same approach as in the First Edition: measuring currency risk separately in the portfolio, clarifying risk responsibility, using specialists where necessary, and taking control of the currency risk. The underlying message remains unchanged: the future currency moves are hard to predict, it is easy by comparison to get reasonably well prepared. This new edition is full of practical hints and tips on how to get prepared in terms of currency risk management.
In the fully updated and expanded Second Edition, you will find:
- An overview of the overlay industry: managers, users, counterparties, custodians, and consultants
- Detailed discussions on the practical choices an investor would have to make on the currency management programme and their implications
- An up-to-date overview on the models and trading strategies researched on and used by practitioners and their performances drivers
- How to deal with emerging market currencies
- The reasons behind the increasing use of currency beta indices and the practical relevance of so-called currency alpha-beta separation
- A practical framework for setting a long-term benchmark hedge ratio
Currency Overlay: A Practical Guide (First Edition) was commended for its systematic approach to the subject, its neutral stance and clear structure, its rigorous yet accessible treatment of theories and academic research on the subject, and, above all, its practical how-to tips. The Second Edition retains all these features and is further enhanced by many useful insights and practical solutions. For investors revisiting their currency management policies and practices (or drafting one for the first time), the advice contained in this book is invaluable.
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About the Author
Table of contents
1 Introduction
1.1 A brief history of the modern currencies
1.2 Some stylised facts about the foreign exchange market
1.3 Defining currency returns
1.4 A simple descriptive tour of currency risks
1.5 What is special about currencies?
1.6 FX risk management and currency overlay
Appendix 1a: Uncovered interest rate arbitrage
Appendix 1b: The correlation triangle
Appendix 1c: Forecast, forward and no-arbitrage price
2 Currency Overlay Management
2.1 Introduction
2.2 Origins and development of currency overlay
2.3 Different approaches to managing currency risks
2.4 Definitions and merits of currency overlay
2.5 What an overlay process looks like in practice
2.6 Trading styles for active overlay and currency pure alpha
2.7 Overview on the main parties involved in currency business
2.8 Historical performance of currency overlay programmes
2.9 Outsourcing currency management
2.10 Summary
Appendix 2a: Main players in the currency overlay market
3 Currency Overlay: Some Practical Choices
3.1 Introduction
3.2 Choices for overall currency management policy
3.3 Choices for passive overlay
3.4 Choices for active overlay
3.5 Choices for pure alpha
3.6 Overlay and prime brokerage
4 FX Research and Choice of Currency Management Styles
4.1 Introduction
4.2 Purchasing power parity (ppp) based models
4.3 Back to fundamentals: macroeconomic models of foreign exchange determination
4.4 Technical analysis
4.5 Two warhorses: carry and trend
4.6 Other types of quantitative forecast models
4.7 Currency beta indices
4.8 Putting research into action
4.9 Summary: relevance of forecast models in a portfolio management context
Appendix 4a: Central bank intervention
Appendix 4b: Foreign exchange and cross-border merger and acquisition announcements
5 Optimisation and Hedge Ratio
5.1 Introduction
5.2 CAPM and currencies
5.3 CAPM, foreign exchange hedging and overlay
5.4 Global optimization and the role of currency
5.5 Hedge ratios
5.6 Asset–liability optimization
5.7 Currency basket hedging
5.8 Sector-based investment and currency management
6 Benchmark Design and Performance Measurement
6.1 Introduction
6.2 Setting a good benchmark
6.3 Customized benchmarks: risk separation and risk responsibility
6.4 Dissecting currency returns
6.5 The currency surprise approach
6.6 The excess return approach
6.7 Holding-based benchmarks
6.8 Adjustment style
6.9 Other practical considerations
7 Overlay and Alpha Beta Separation
7.1 Introduction
7.2 Alpha and beta for currencies
7.3 The rationale behind passive overlay plus pure alpha
7.4 The best implementation methods and other considerations
8 Options, Dynamic Hedging and Overlay
8.1 Introduction
8.2 Option pricing theory and dynamic hedging
8.3 Skews and smiles
8.4 Trading opportunities in the options market
8.5 Speaking Greek – some closing comments
9 Emerging Market Currencies
9.1 Background
9.2 The hedging debate in EM currencies
9.3 Carry, trend and value in EM currencies
9.4 Use options to trade EM currencies
9.5 Other related issues
9.6 Summary
10 Liquidity, Counterparty Risk and E Commerce
10.1 Introduction
10.2 Foreign exchange liquidity: theory and reality
10.3 Counterparty credit risk
10.4 E-commerce
11 Conclusions
11.1 Summary of the main arguments
11.2 A practical framework of setting benchmark hedge ratios
11.3 A currency overlay checklist
[List of currencies]