Tag: Currency
Oct
25
Options Granted to Bondholders
A bond issue may include a provision that gives either the bondholder and/or the issuer an option to take some action against the other party. The most common type of option embedded in a bond is a call feature, which was discussed earlier. This option is granted to the issuer. There are two options that can be granted to the bondholder: the right to put the issue and the right to convert the issue.
An issue with a put provision grants the bondholder the right to sell the issue back to the issuer at a specified price on designated dates. The bond with this feature is called a putable bond and the specified price is called the put price. The advantage of the put provision to the bondholder is that if after the issue date market rates rise above the issue’s coupon rate, the bondholder can force the issuer to redeem the bond at the put price and then reinvest the proceeds at the prevailing higher rate.
A convertible bond is an issue giving the bondholder the right to exchange the bond for a specified number of shares of common stock. Such a feature allows the bondholder to take advantage of favorable movements in the price of the bond issuer’s common stock. An exchangeable bond allows the bondholder to exchange the issue for a specified number of shares of common stock of a corporation different from the issuer of the bond.
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Nov
19
MANAGING FOREIGN EXCHANGE RATE RISK
Banks are exposed to a number of potential foreign exchange risks. Foreign exchange risks may arise as a result of cash exposures or from exposures to instruments denominated in a foreign currency. Risks arise when there is a mismatch between the value of assets it owns denominated in a foreign currency and the value of what it owes in the same currency. A mismatch may also occur as a result of payments it expects to receive, or is committed to make, in a foreign currency at a future time. The former exposures are referred to as spot positions and the latter forward positions:
Long.A bank may have a long spot foreign currency position if it has foreign currency in the form of cash or owns an asset denominated in a foreign currency. It may have a long forward position if it expects to receive a future payment in a foreign currency or expects to receive an asset at a future date that is denominated in a foreign currency. Short. A bank may have a short spot foreign currency position if it owes foreign currency in the form of cash (for example, in the form of a deposit taken by a bank in a foreign currency) or a financial instrument denominated in a foreign currency. It may have a short forward position if it is committed to making a future payment in a foreign currency or to deliver an asset at a future date that is denominated in a foreign currency.
The overall spot and forward position is calculated for each foreign currency by adding up the individual spot and forward positions in that currency. It has a flat position if its assets in one currency are equal to its liabilities in both the spot and forward markets.
A US bank that has a long spot position in euros worth $100m at current exchange rates but also owes yen to the value of $100m does not have a flat position. It has a long euro position and a short yen position. If the bank also owes the equivalent of $100m in euros at current exchange rates for delivery in one month’s time the bank does have a flat euro position overall even though it is long in the spot market and short in the forward.
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Jul
06
Passive Currency Management
Passive currency hedging or currency management involves the creation of a currency hedging benchmark and sticking to that benchmark come what may, avoiding any slippage. As a result, it involves the taking of standard currency hedges and then continuing to roll those for the life of the investment. The two obvious ways of establishing a passive hedging strategy are for instance:
Three-month forward (rolled continuously)
Three-month at-the-money forward call (rolled continuously)
The advantage of passive currency management is that it reduces or eliminates the currency risk (depending on whether the benchmark is fully or partially hedged). The disadvantage is that it does not incorporate any flexibility and therefore cannot respond to changes in market dynamics and conditions. Passive currency management can be done either by the portfolio manager themselves or by a currency overlay manager, and focuses on reducing the overall risk profile of the portfolio.
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Jul
04
CURRENCY MARKETS ARE DIFFERENT
Throughout this blog, we have looked, albeit from varying perspectives, at the governing dynamics that drive the global currency markets. If we have learned one thing, it is surely this, that the currency markets are by their nature predominantly “speculative”. That is to say, the majority of currency market participants are what we would define as “speculators”, using the definition of this blog for currency speculation as the trading or investing in currencies without any underlying, attached asset. The predominance of speculation within currency markets is neither a good nor a bad thing. On the one hand, it provides needed liquidity for those aspects of the economy deemed productive rather than speculative. On the other hand, it can and frequently does lead to overshooting relative to perceived economic fundamentals.
The speculative nature of the currency markets may be an important reason why most long-term fundamental equilibrium models work poorly in trying to forecast exchange rates. At the least, it serves as an excellent excuse for those who otherwise are unable to forecast exchange rates using the traditional methods. All of this may be true, and all of it makes for a very different world from those of the equity or fixed income, markets. By necessity, these are not speculative by nature since they are themselves underlying assets relating to the economy in some way. This is not at all to suggest that speculation does not occur in equities or fixed income, for any such suggestion would clearly be foolish. The recent bubble in the NASDAQ should serve as an excellent warning for any who think these markets are always fundamentally-driven and incapable of speculative excess. That said, this same example is surely notable by its rarity. Throughout history, there have indeed been examples of speculative excess across all markets. In equity and fixed income markets, relative to “normal” conditions however, these are the exception rather than the rule. This is not the case in currency markets, where traditional economic theory has all but given up trying to explain short-term moves and longer-term exchange rate models have far from perfect results.
The dynamics of the asset and currency markets are “fundamentally” different. Therefore these risks should be dealt with separately and independently from one another. For the international equity fund manager, investing in a country is not the same and should not be the same decision as investing in a country’s currency. Eventually, they may have the same risk profile over a long period of time. However it is questionable whether the investor’s tracking error and Sharpe ratio, not to say the investor themselves, should have to go through that degree of stress!
Equally, currency is not the same as cash. An individual investor may treat currency as cash from a relative performance perspective. Unfortunately, however, such a comparison provides a false picture. Most currency market participants, and therefore the currency market as a whole, do not buy or sell currencies for the income that a “cash” description would of necessity entail. On the contrary, they do so for anticipated directional or capital gain. In other words, they are seeking to profit from precisely the risk that the investor is not hedging! It is a generalization, but nevertheless true that the reluctance to manage currency risk is far more predominant among equity fund managers thanfixed income fund managers. That may have something to do with the intended tenor of the investment, suggesting fixed income fund managers may be more short-term in investment strategy than their equity counterparts. Any such view seems greatly oversimplistic, and would require a study on its own to verify or otherwise. Many cannot manage currency risk simply because the rules of their fund do not allow them so to do. There remains however a substantial community of institutional investors who apparently have yet to be convinced by either the merits or the need to manage currency risk separately. By the end of this series of posts, it is my hope that I will have caused many within this community to at least reconsider their view as regards currency risk. To summarize this part, the way currencies and underlying assets are analysed and the way they trade are both different from each other. Consequently, the way they should be managed should also be different.
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