The 4 principles for currency management

How to deal with multi-currency investments? Nowadays institutional investors hold well diversified portfolios with global investments. Given the fact that the investments are spread out all over the world, a currency dimension is introduced. The investors have exposure to different currencies. As institutional investors often have their liabilities in their home currency, this creates a discrepancy and introduces currency risk.

This currency risk can be managed on a total fund level or on portfolio level. In our example below we assume it is managed on total level, however the same principles apply on portfolio level. Research and experience over the past decades have shown us that there are four main principles to manage currency risk. And also what the important questions are to consider when managing that risk.

The four main principles to manage your currency risk:

1. Measure the currency exposure in your investments
It is crucial to measure and know how much actual currency exposure you have on a total fund level. It sounds like a very easy common principle, however we still observe that a lot of institutions don’t have this information at hand on a frequent basis. One complexity that we often observe, is the investments in pooled funds or ETF’s. The investor does not know the exact holdings of the investment and therefore does not know the exact currency exposure. This would require look through, which is applied by many of our clients.

2. Determine how much currency exposure is desirable
Why would you take any currency risk? This is an important question funds should ask themselves. Looking at historical data, one can observe that in the long run there is no or a very small currency risk premium to be gained. As a fund it is therefore important to make an explicit decision whether you would like to take currency risk and how much risk you would like to take. For example, I would like to only leave my US dollar position 50% open, all other currencies should be hedged. As a fund you could add how strict these guidelines are. Are your currency managers allowed to impose their own shorter term outlook and deviate from this strategical view?

3. Measure how much currency exposure is managed
Once you have decided on principle 2; how much exposure you would like to have to each different currency, one should measure if your (external or internal) currency manager is indeed hedging the agreed amount or whether the manager is deviating from the strategical view. In other words, just like principle 1, measure at any point in time how much currency is being hedged by your currency manager. A specific issue that often comes up, is how to deal with currencies that are difficult to find hedges for. For example, how to hedge the Korean Wong, do you allow proxy hedges?

4. Compare actual vs desired vs managed and take action
Finally, by comparing principle 1, 2 and 3, you should get a good grip on how much currency risk you are still facing as a fund. This also allows you to act timely whenever the difference between the actual currency exposure and the desired exposure is becoming too big.
As in many cases you need to be able to measure before you can manage your currency risk.

Read more on multi-currency investing: IRR calculation in a multi-currency environment