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FOR WHOLESALE CLIENTS ONLY. NOT TO BE DISTRIBUTED TO RETAIL CLIENTS. NOT TO BE REPRODUCED WITHOUT PRIOR WRITTEN APPROVAL. PLEASE REFER TO ALL RISK DISCLOSURES AT THE BACK OF THIS DOCUMENT.
CURRENCY RISK MANAGEMENTA GUIDE FOR AUSTRALIAN SUPERANNUATION FUND TRUSTEES
MARCH 2017
Most Australian superannuation funds have
significant exposure to overseas investments, the
side effect being the acquisition of currency risk.
This has led many superannuation funds to adopt
currency risk management (CRM) strategies,
which can help funds to reduce risk and improve
performance over time, increasing the probability
that they will achieve their investment goals.
This document introduces the principles behind
CRM, the various CRM solutions available and how
to decide on the appropriate approach for your
superannuation fund.
3
CONTENTSINTRODUCTION TO CURRENCY RISK MANAGEMENT // 4
CURRENCY RISK MANAGEMENT: THE BASICS // 6
MANAGING CURRENCY RISK // 7
PASSIVE CURRENCY OVERLAY // 7
ACTIVE CURRENCY OVERLAY // 8
EMERGING MARKET CURRENCY OVERLAY // 10
CUSTOMISING THE CURRENCY SOLUTION // 11
HOW TO IMPLEMENT CRM //12
FREQUENTLY ASKED QUESTIONS // 13
APPENDIX: HOW CURRENCY FORWARDS WORK // 14
ABOUT INSIGHT INVESTMENT // 14
4
THE IMPACT OF EXPOSURE TO CURRENCY
Currency exposure comes as a by-product of investing in
international assets. The return on international assets is therefore
the sum of the foreign asset return and the currency return (see
Figure 1).
Investors may expect international assets to deliver a positive
return over the long term. However, it is generally agreed that
there is no long-term expected return associated with passive
exposure to developed market currencies. The majority of a fund’s
currency risk is therefore referred to as an unrewarded risk.
In the short term, currency risk can be beneficial or detrimental, and considerably so, as can be illustrated by examining the annual
currency returns from exposure to the US equity market (see Figure 2). In recent years the impact of currency has been positive, whereas
currency exposure over the period following the global financial crisis (GFC) of 2008 would have imposed a performance drag on a fund’s
overseas investments. The average annual currency return over the period has been only 1.33%, but the maximum and minimum values
have been significant at -25% and +26% respectively. This is in contrast to the equity component, which has been a more reliable generator
of positive performance.
Given a static exposure to foreign currency is not expected to deliver a long-run positive return, the potential for it to generate short to
medium-term losses has prompted many superannuation funds to consider the management of their currency risks as a high priority.
TO ACHIEVE SUFFICIENT ASSET DIVERSIFICATION AUSTRALIAN SUPERANNUATION FUNDS ARE COMPELLED TO
DIVERSIFY INTO OFFSHORE ASSETS. THE TYPICAL SUPERANNUATION FUND DEFAULT OPTION WILL HOLD OVER
30% IN INTERNATIONAL ASSETS SPREAD ACROSS EQUITIES, FIXED INCOME AND ALTERNATIVES, AND THOSE
ASSETS WILL BE SUBJECT TO CURRENCY RISK.
INTRODUCTION TOCURRENCY RISK MANAGEMENT
Figure 2: Equity and currency returns compared
-50
-25
0
25
50
2016201320102007200420011998199519921989
%
■ Calendar year returns of the MSCI USA Total Return Index
-30
-20
-10
0
10
20
30
20162013 20102007200420011998v199519921989
%
■ Calendar year currency contribution to returns from the MSCI USA Total Return Index (reflecting the AUD/USD exchange rate)
Source: Datastream, Thomson Reuters and Insight. As at 31 December 2016.
Figure 1: Total offshore investment returns are the sum of foreign
asset return in offshore currency terms and currency return
+=ASSET RETURN IN OFFSHORE
CURRENCYTERMS
TOTALOFFSHOREINVESMENT
RETURN
CURRENCYRETURN
5
The focus on reducing return volatility by adopting a suitable strategic hedge ratio is a common starting point for a currency risk
management solution. However, doing so typically brings with it a level of cash flow volatility, which should be carefully considered. Asset
managers can help investors to consider these factors, and have helped develop and implement new risk management solutions to reflect
the specific sensitivities of superannuation funds (see Figure 3).
In addition to reducing risk, currency risk management solutions can also assist in generating return. This is achieved by moving currency
hedges away from the chosen strategic level in certain environments, so that over time currency losses are reduced by more than currency
gains (see Figure 4).
An additional benefit of an active currency hedge is the ability to manage the potential cash flow implications of a passive hedge (see pages
7 and 11 for more information).
Figure 3: Passive currency risk management will typically reduce volatility of returns
Retu
rn
Time
Offshore investment return with unhedged currency exposureOffshore investment return with passively hedged currency exposure
Figure 4: Active currency risk management aims to manage currency exposure to increase the positive contribution over time
Retu
rn
Time
Offshore investment return with unhedged currency exposureTarget outcome for offshore investment return with actively hedged currency exposure
Figures 3 and 4: For illustrative purposes only.
6
Adopting a currency risk management programme involves putting in place currency hedges, unless the policy is to be passively 0%
hedged. Doing so will impact the outcomes experienced by a fund in terms of return and cash flow.
ADOPTING A STRATEGIC HEDGE RATIO
A currency risk management solution begins with establishing a strategic hedge ratio appropriate for the fund. A number of factors can
influence this decision, and it is important to recognise the impact that different hedge ratios have on the potential return outcomes of the
fund. If a strategic hedge ratio of 0% hedged is chosen, the fund will be exposed to all of the foreign currency gains and losses that occur,
which can be large (see Figure 5).
The potential outcomes of the 0% hedged position can be displayed with the use of a payoff diagram (see Figure 6). The diagram illustrates
that as foreign currencies appreciate or depreciate, the currency return experienced increases or decreases respectively by exactly the
same amount. Alternative strategic hedge ratios may be adopted, such as a 100% hedged position, where the currency return experienced
is zero, regardless of movements in foreign currencies. While initially appealing, the 100% hedged position does not remove all currency
risks. Currency hedges generate cash flows designed to offset the movements in the foreign currencies, which can be large (as shown in
Figure 2). As a consequence, adopting a 100% hedged position as foreign currencies appreciate could lead to costs accruing as a result of
the derivative contracts used to implement the hedge.
The appropriate strategic hedge ratio can lie anywhere in between 0% and 100%, and increasing the hedge ratio effectively reduces currency
risk in return for currency cash flow risk. The strategic hedge ratio should generally be chosen for the long run and so should provide the
appropriate mix of these two risks. A specialist asset manager will typically provide support for investors considering what ratio to adopt.
DEVIATING FROM THE STRATEGIC HEDGE RATIO
Once the strategic hedge ratio is chosen, in certain currency environments it may be deemed favourable to move hedges away from
that level in the short term. A CRM solution should establish the degree to which that is possible, and also the processes used to make
these changes.
SUPERANNUATION FUNDS ARE EXPECTED TO PROVIDE A RANGE OF INVESTMENTS WHICH WILL
EVENTUALLY BE USED TO PROVIDE RETIREMENT INCOME FOR MEMBERS. TO ACHIEVE THIS, THEY NEED
TO ENSURE AN APPROPRIATE SOLUTION IS IN PLACE TO MANAGE THE CURRENCY RISK BORNE BY THEIR
INTERNATIONAL INVESTMENTS.
CURRENCY RISK MANAGEMENTTHE BASICS
Figure 5: Currency returns can be volatile over time
-20
-10
0
10
20
30
40
50
60
70
1988 1992 1996 2000 2004 2008 2012 2016
Cum
ulat
ive
retu
rn (%
)
Unhedged return from the MSCI Developed Market World ex Australia Index (reflecting the AUD/USD exchange rate)
Figure 6: Difference between a zero and 100% currency hedge
0% Hedged
Foreign currencyappreciation
Foreign currencydepreciation
Gain
Loss
Strategy return
100% Hedged
Figure 5: Source: Datastream, Thomson Reuters and Insight. As at 31 December 2016. Figure 6L For illustrative purposes only.
7
PASSIVE CURRENCY OVERLAY
A passive currency solution should aim to implement the strategic hedge ratio as efficiently as possible. Asset managers can also assist
superannuation funds with the strategic hedge ratio decision. Although this can be swayed by strong views on the future direction of the
Australian dollar or by the hedging decisions of peer group funds, it should depend more on the fund’s sensitivities to cash flow and the
characteristics of the underlying assets.
Investors should therefore consider the following when deciding on the passive strategic hedge ratio:
Sensitivity to negative cash flows
Passively implementing a strategic hedge requires the construction of an overlay of currency forwards that require periodic cash
settlement. These hedging instruments can occasionally require large cash payments from the fund to settle hedging losses. An
explanation of forwards and how they work is given in the appendix.
The higher the strategic hedge ratio chosen, the greater the potential for negative cash flows. If a fund is sensitive to cash flows, there is an
implied maximum hedge ratio the fund can tolerate. Scenario analysis is useful for revealing this implied maximum, as it shows what
negative cash flows may occur for the fund in various Australian dollar weakening environments (see Figure 7).
Potential for diversification benefits
Passively hedging currency can reduce currency risk. At times this risk can be beneficial from a diversification standpoint, as it can reduce
the overall volatility of the offshore portfolio.
This diversification benefit increases as the correlation between movements in offshore assets and currencies decreases. For Australian
superannuation funds whose base currency is the Australian dollar, this benefit has at times been more evident for international equity
holdings rather than fixed income portfolios, as the Australian dollar has tended to fall alongside global equity markets (see Figure 8).
Given that currency has a much larger impact on overall volatility for fixed income rather than equities, many investors have decided to
adopt lower strategic hedge ratios for international equities than for fixed income.
A CURRENCY RISK MANAGEMENT SOLUTION MAY IMPROVE A SUPERANNUATION FUND’S RISK PROFILE
AND ENHANCE RETURNS. TO MANAGE CURRENCY RISK INVESTORS MUST DECIDE ON THREE THINGS: THE
STRATEGIC HEDGE RATIO (A PASSIVE APPROACH), IF AND HOW TO DEVIATE FROM THE STRATEGIC HEDGE
RATIO (AN ACTIVE APPROACH), AND WHAT TO DO FOR EMERGING MARKET CURRENCIES.
MANAGINGCURRENCY RISK
Figure 7: Potential cash flow impact of a move in the
Australian dollar
Hedge Ratio
Fall in the
Australian
dollar
100% 75% 50% 25%
10% Fall -$35m -$26m -$18m -$9m
20% Fall -$70m -$53m -$35m -$18m
30% Fall -$105m -$79m -$53m -$26m
40% Fall -$140m -$105m -$70m -$35m
• AUD1bn superannuation fund• 35% off shore
• 3% in cash (AUD30m)
Figure 8: Diversification benefits of currency exposure can vary
Annualised volatility (%)
0 5 10 15 20 25
Fixed income market includingcurrency exposure
Currency
Fixed income
Equity market includingcurrency exposure
Currency
Equity 12.8
10.4
13.3
3.0
9.9
10.3
Materialdiversification benefit
Limiteddiversification benefit
Figure 7: Source: Insight. For illustrative purposes only. Figure 8: Source: Bloomberg, Datastream, Thomson Reuters, Insight. Volatility is calculated over the period from 1 February 1990 to 31 December 2016. Equity markets are represented by the MSCI Developed Market World ex Australia Index; fixed income markets are represented by the Barclays Global Aggregate Total return Index. Data based on monthly returns.
8
ACTIVE CURRENCY OVERLAY
In order to better manage currency risk, superannuation funds may consider introducing the flexibility to deviate away from the strategic
hedge ratio in certain environments.
When foreign currencies are depreciating versus the Australian dollar the best position to adopt is 100% hedged (see Figure 9). Conversely,
when foreign currencies are appreciating versus the Australian dollar the best position to adopt is 0% hedged. Managing currency exposure
to reflect currency movements in this way would result in the perfect currency hedge, and it is the objective of an active currency risk
management solution to attempt to achieve this. The perfect currency hedge is shown in Figure 9 as the ‘ideal outcome’.
The larger the appreciation or depreciation in a foreign currency, the further away from the ideal outcome the payoff from a passive
currency hedge may be. This can lead to significant regret, which underlies the importance to many investors of an active process for
managing currency risk.
Figure 9: The ideal outcome - the theoretical objective of an active currency risk management overlay
0% Hedged
Foreign currencyappreciation
Foreign currencydepreciation
Gain
Loss
Strategy return
100% Hedged
Reduce translation lossof unhedged position
Reduce cash flow lossof hedged position
Ideal outcome
Source: Insight. For illustrative purposes only.
9
Factors driving currencies
Asset managers can provide active CRM solutions that automatically adjust hedge ratios as the currency landscape evolves. This can prove
to be beneficial, especially in periods where the Australian dollar rises or falls considerably over a short period of time. Leading asset
managers will make active hedge ratio adjustments based on various factors. There are four main factors that are widely acknowledged to
affect currency behaviour:
Currency valuation
From an economic standpoint, exchange rates are expected to revert to fair value over the long term, and fundamental information can be
used to create estimates of fair value. As foreign currencies become further over- or under-valued, this factor can help to position hedge
ratios higher or lower in anticipation of a reversal to fair value.
Interest rate carry
The difference between the interest rates of two countries can drive exchange rate activity over the medium term, as investors direct their
capital towards the higher yielding currency. As this factor changes, it can help to adjust hedge ratios in order to benefit from this relationship.
Spot rate momentum
Exchange rates have a tendency to exhibit trending behaviour over multiple years and incorporating a momentum signal into one’s
investment process can prove to be a valuable tool, as not adjusting a hedge ratio during an exchange rate trend can prove costly.
Spot rate volatility
When an exchange rate is not trending in a particular direction, it can oscillate within a range. Models can attempt to recognise when these
periods occur, and then position hedges for expected short-term reversals in exchange rates.
Figure 10: Currency valuation factor
Time
Cha
nge
in s
pot
Under-valued
Over-valued
Fair Value (PPP)
Figure 11: Interest rate carry
Carry
Time
Inte
rest
rat
e di
ffer
entia
l
Figure 12: Spot rate momentum
Momentum Momentum
Time
Cha
nge
in s
pot
Figure 13: Spot rate volatility
Volatility Volatility
Time
Cha
nge
in s
pot
Figures 10, 11, 12 and 13 are for illustrative purposes only.
10
EMERGING MARKET CURRENCY OVERLAY
As superannuation funds’ exposure to emerging market assets has increased, the currency problem that these investments generate has
become increasingly pervasive. Emerging market currencies behave differently to developed market currencies and so warrant a different
risk management approach.
Generally speaking, it is broadly acknowledged that there is no reason to expect one developed market currency to appreciate versus
another over the long term. However, there are economic reasons to expect emerging market currencies to appreciate relative to
developed market currencies over time. This may be part of the reason why superannuation funds tend to choose 0% hedged as their
strategic hedge ratio for emerging market exposures. However, adopting this position does not manage the associated currency risk.
For Australian investors, exposure to emerging market currencies has been volatile, with almost as many negative years as positive ones
(see Figure 14). However, relative to a diversified basket of developed market currencies, the return from emerging market currencies has
been broadly positive over the long term (see Figure 15). This is the emerging market currency risk premium that most investors are
implicitly trying to capture. Australian investors have not benefited from this risk premium because of the movements of the Australian
dollar relative to its developed market counterparts (see Figure 16).
It is possible to manage this Australian dollar-specific risk, so as to increase the probability that a superannuation fund realises the emerging
market risk premium. This would require an overlay using forward contracts, meaning an active approach may be more appropriate to limit
the potential for negative cash flows introduced by using hedging instruments.
Figure 14: Impact of unhedged currency exposure on emerging market investment performance for AUD investors
-25
0
25
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
%
■ Performance impact
-25
0
25
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
%
■ Performance impact
-25
0
25
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
%
■ Relative performance
Figure 15: Impact of unhedged currency exposure on emerging market investment performance, when offset against exposure to an
equally weighted basket of developed market currencies
-25
0
25
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
%
■ Performance impact
-25
0
25
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
%
■ Performance impact
-25
0
25
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
%
■ Relative performance
Figure 16: Performance of an equally weighted basket of developed market currencies relative to the AUD
-25
0
25
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
%
■ Performance impact
-25
0
25
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
%
■ Performance impact
-25
0
25
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
%
■ Relative performance
Source: Datastream, WM Reuters and Insight. As at 31 December 2016. Impact of unhedged currency exposure to emerging markets for AUD investors represented by the difference in performance between the AUD-hedged/AUD-unhedged versions of the MSCI Emerging Market Index. Equally weighted basket of developed market currencies split between CAD, CHF, EUR, GBP, JPY and USD.
11
A CRM mandate is a customised solution set up to manage the specific currency risk emanating from the underlying portfolio of a particular
superannuation fund. However, there are three further ways the fund might fine tune the behaviour of the programme so as to target
desired outcomes.
AN EFFECTIVE CURRENCY RISK MANAGEMENT SOLUTION WILL BE IMPLEMENTED IN A WAY THAT RESPECTS
THE CONSTRAINTS OF A PARTICULAR SUPERANNUATION FUND. BEING ABLE TO CUSTOMISE THE SOLUTION
TO RESPECT THESE PREFERENCES IS CRITICAL TO ENSURE THAT THE TAILORED INVESTMENT OUTCOMES
ARE ACHIEVED.
CUSTOMISINGTHE CURRENCY SOLUTION
Figure 17: Limits can be applied to the maximum cash loss
0% Hedged
Foreigncurrency
appreciation
Foreigncurrency
depreciation
Gain
Loss
Strategy return Ideal outcome
Maximum cash loss limit100% Hedged
MAXIMUM CASH LOSS
A CRM solution will require the use of forward contracts which
brings with it the risk of negative cash flows (see the appendix for
an explanation of forward contracts). An attractive feature for a
CRM solution may be the imposition of a risk control on cash
flow such that the total amount that might be paid out over a
specified period should not exceed a specified amount. This can
be illustrated as a limit relative to the 0% hedged position (see
Figure 17). This risk control will generally have an impact as
foreign currencies appreciate versus the Australian dollar,
decreasing the size of currency hedges.
Figure 19 : Limits can be applied to the maximum benchmark-
relative loss
0% Hedged
Foreigncurrency
appreciation
Foreigncurrency
depreciation
Gain
Loss
Strategy return
100% Hedged
Ideal outcome
50% Hedged
Maximum benchmark-relative loss limit
MAXIMUM BENCHMARK-RELATIVE LOSS
For active CRM programmes, it is important to establish ahead of
time the degree to which the performance outcome can lag that
of the superannuation fund’s strategic hedge ratio. This is strictly a
downside risk control, with the potential for benchmark-relative
gains not being curtailed. Once again this risk control can be
illustrated on the payoff, as a limit relative to the superannuation
fund’s chosen strategic hedge ratio. In the example shown in
Figure 17 the strategic hedge ratio is 50%.
Figure 18: Limits can be applied to the maximum currency loss
0% Hedged
Foreigncurrency
appreciation
Foreigncurrency
depreciation
Gain
Loss
Strategy return
100% Hedged
Ideal outcome
Maximum currency loss limit
MAXIMUM CURRENCY LOSS
The imposition of a risk control on total absolute currency
return, such that the total currency loss over a specified period
should not exceed a specific amount, may also be attractive.
This can be illustrated as a limit relative to the 100% hedged
position. This risk control would generally have an impact as
foreign currencies depreciate versus the Australian dollar,
increasing the size of currency hedges.
Figures 17, 18 and 19 are for illustrative purposes only.
12
THE STRUCTURE
A CRM solution is typically put in place as a segregated mandate, where every factor is designed and implemented by the asset
manager specifically for the fund. These mandates can be designed to manage currency risk at the asset class level, the member option
level, or holistically.
• Traditionally CRM mandates have been implemented at the asset class level as superannuation funds have tended to require different
approaches for different asset classes. As an example, a passive mandate with a strategic hedge ratio of 100% hedged might be adopted
for an international fixed income portfolio, whereas an active mandate with a strategic hedge ratio of 50% hedged might be chosen for
an international equity portfolio.
• Superannuation funds might find it more suitable to implement CRM mandates at the member options level. It could be argued that as
the risk level of the option changes, an active approach may be more or less appropriate. Similarly, where applicable, different strategic
hedge ratios might be deemed appropriate for the various cohorts of lifecycle funds.
• The holistic approach to managing currency risk has become more popular as funds recognise the fact that currency risk can affect all
asset classes in the same way. Under the holistic method, all currency risk is managed via a single overlay, which leads to investment
and operational efficiencies.
REGULATION, TAX AND EXECUTION
The ever-changing regulatory landscape has had some implications for currency overlay strategies recently. The reporting burden
increased in 2013 as the Australian Securities and Investments Commission (ASIC) published the ASIC Derivative Transaction Rules, which
set out the requirements for counterparties to report derivative transaction and position information to derivative trade repositories.
In 2015 the Australian Taxation Office issued guidance on determining the source of hedging gains for the purposes of applying the foreign
tax offset limit. This ruling meant that there was a potential tax benefit from executing derivatives with domestically located counterparties.
Regulation can have an impact on liquidity which is why now, more than ever, a focus on derivative execution and counterparty risk
management is paramount. Leading asset managers understand the need to support their clients with their regulatory requirements,
and to provide sufficient counterparty diversity in order to preserve liquidity and ensure best execution. Independent transaction cost
analysis providers may also be engaged so that superannuation funds can keep a close eye on the efficiency of the execution of their
chosen asset manager.
THE ASSET MANAGER
CRM solutions are complex and can transform a superannuation fund’s investment outcome. They require a manager with knowledge of
superannuation funds’ underlying portfolios and their tolerances for currency returns and cash flows, a deep understanding of current
market conditions and extensive experience in derivative markets.
As a result, selecting the right asset manager could be the most important factor in how a superannuation fund implemented its decision to
manage currency risk.
THE PRINCIPLES BEHIND CURRENCY RISK MANAGEMENT ARE RELATIVELY STRAIGHTFORWARD, BUT IN REALITY
IMPLEMENTATION CAN BE COMPLEX. BEFORE EMBARKING ON A CRM STRATEGY FOR YOUR SUPERANNUATION
FUND, THERE MAY BE SEVERAL FACTORS TO CONSIDER.
HOW TOIMPLEMENT CRM
13
Are CRM solutions only for large superannuation funds?
No. The principles behind CRM are applicable to superannuation funds of all types and sizes. However, the extent to which assets are
invested offshore is relevant. The larger the international allocation of a fund, the more currency risk, and the larger the potential positive
impact of a passive or active currency programme.
Does CRM mean giving up control of investment decisions relating to currency hedging?
Many asset managers offer a choice of levels of service, allowing investors to choose between passive or active mandates. For active
mandates a superannuation fund will typically retain control over the strategic hedge ratio, the extent to which the manager can deviate
from it, and the degree which it can underperform it over a specific time period.
Do passive CRM solutions manage cash flows?
As opposed to active solutions, passive currency overlay solutions do not manage cash flows, and the higher the strategic hedge ratio
chosen by the superannuation fund, the larger the size of the potential positive and negative cash flows. This cash flow risk can be
mitigated somewhat by employing a customised forward contract maturity schedule. This way, settlements can be structured to occur at a
favourable frequency so that cash flows are smoothed.
Will active CRM solutions limit currency losses?
Active CRM solutions will attempt to reduce the size of the negative returns and negative cash flows related to exposure to foreign
currencies. Leading currency risk managers can also customise currency solutions in order to minimise the chance that specified negative
return or cash flow outcomes occur.
Can CRM solutions lead to an increase in volatility?
A passive currency overlay, effectively implemented, will always reduce currency return volatility. However, depending on how currencies
move in relation to the underlying investments, a passive mandate may increase volatility at the fund level. An active currency overlay will
aim to reduce currency losses, which is consistent with the objective of maximising the risk-adjusted return available from the existing
exposures. This may lead to an increase in volatility but, if the solution is effectively implemented, it should be compensated by a
commensurate increase in return. Leading asset managers can also create active currency solutions which have the explicit objective of
minimising total portfolio volatility by taking into consideration how currencies move with respect to underlying assets.
Do currency risk management solutions use complicated derivatives?
Currency risk management solutions use derivatives, but they do not need to be complicated. The derivatives market today is one of
the largest in the world, and the ubiquity and flexibility of derivatives mean that they are a central feature of twenty-first century risk
management. Leading CRM managers are highly experienced at managing the risks associated with derivatives through processes
including the management of counterparty risk and settlement risk.
Is an active CRM approach the best way to generate currency alpha?
Active currency risk management solutions may be expected to help deliver return outcomes that are superior to that of a superannuation
fund’s stated benchmark over the long term. However, this is typically a positive side effect of successful risk management, rather than
an explicit objective of a CRM mandate. If a superannuation fund wishes to generate an investment return from currency exposure, a
specialised currency absolute return portfolio is likely to be a more suitable approach.
FREQUENTLY ASKEDQUESTIONS
14
APPENDIXHOW CURRENCY FORWARDS WORK
INSIGHT INVESTMENT IS A LEADING ASSET MANAGER FOCUSED ON DESIGNING INVESTMENT SOLUTIONS TO
MEET OUR CLIENTS’ NEEDS. LAUNCHED IN 2002, INSIGHT IS RESPONSIBLE FOR ASSETS UNDER MANAGEMENT
OF AUD893BN1 ACROSS LIABILITY-DRIVEN INVESTMENT, CURRENCY RISK MANAGEMENT, ABSOLUTE RETURN,
FIXED INCOME, CASH MANAGEMENT, MULTI-ASSET AND SPECIALIST EQUITY STRATEGIES.
ABOUTINSIGHT INVESTMENT
ITING CONTENT
Insight is committed to providing a broad spectrum of investment and risk management solutions, partnering with clients to build
sophisticated portfolios to achieve their desired outcomes. Insight’s ability to create tailored and highly cost-effective solutions makes our
proposition compelling for a wide range of investors, including superannuation funds, insurers, sovereign wealth funds and individuals.
Our investment and client service teams have a long-standing record that demonstrates their success, whether a client needs a wide
ranging holistic solution or a specific strategy to achieve their goals.
CURRENCY FORWARDS ENABLE SUPERANNUATION FUNDS TO HEDGE THEIR CURRENCY RISKS. FORWARDS RISE
AND FALL IN VALUE AS SPECIFIED FOREIGN CURRENCY EXPOSURES FALL AND RISE, THEREBY OFFSETTING THE
RELEVANT CURRENCY RETURNS.
A forward is an agreement between two parties to buy or sell an asset at a specified future time, at a price agreed today. For currency
forwards, the asset is foreign currency and the price is the exchange rate.
A currency forward contract is a derivative instrument that can be used to hedge currency risks until the contract’s maturity date. At the
contract’s inception the value of the contract is zero. However, as the exchange rate begins to change the value of the contract will
fluctuate, and a gain or loss will accrue. If the contract has been used correctly, the gain or loss will offset the return that the currency
exposure creates, thereby hedging the currency risk. The gain or loss that is outstanding when the contract matures needs to be
exchanged with the counterparty and when this occurs the forward contract is said to be settled. Currency hedging involves the
construction of an overlay of forward contracts with settlements occurring regularly.
1 As at 31 December 2016. Assets under management (AUM) are represented by the value of cash securities and other economic exposure managed for clients. Figures shown in AUD. FX rates as per WM Reuters 4pm Spot Rates. Reflects the AUM of Insight, the corporate brand for certain companies operated by Insight Investment Management Limited (IIML). Insight includes, among others, Insight Investment Management (Global) Limited (IIMG), Pareto Investment Management Limited (PIML), Cutwater Asset Management Corp. (CAMC), Cutwater Investor Services Corp. (CISC) and Insight North America LLC (INA), each of which provides asset management services.
FIND OUT MORE
Insight Investment
Level 2, 1-7 Bligh Street,
Sydney NSW 2000
+61 2 9260 6655
Bruce Murphy
Director, Australia and New Zealand
Margaret Waller
Director, Investment Strategy
www.insightinvestment.com
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For clients and prospects of Insight Investment Management (Global) Limited: Issued by Insight Investment Management (Global) Limited. Registered in England and Wales. Registered office 160 Queen Victoria Street, London EC4V 4LA; registered number 00827982.
For clients and prospects of Insight Investment Funds Management Limited: Issued by Insight Investment Funds Management Limited. Registered in England and Wales. Registered office 160 Queen Victoria Street, London EC4V 4LA; registered number 01835691.
For clients and prospects of Pareto Investment Management Limited: Issued by Pareto Investment Management Limited. Registered in England and Wales. Registered office 160 Queen Victoria Street, London EC4V 4LA; registered number 03169281.
Insight Investment Management (Global) Limited, Insight Investment Funds Management Limited and Pareto Investment Management Limited are authorised and regulated by the Financial Conduct Authority in the UK. Insight Investment Management (Global) Limited and Pareto Investment Management Limited are authorised to operate across Europe in accordance with the provisions of the European passport under Directive 2004/39 on markets in financial instruments.
For clients and prospects based in Singapore: This material is for Institutional Investors only. This documentation has not been registered as a prospectus with the Monetary Authority of Singapore. Accordingly, it and any other document or material in connection with the offer or sale, or invitation for subscription or purchase, of Shares may not be circulated or distributed, nor may Shares be offered or sold, or be made the subject of an invitation for subscription or purchase, whether directly or indirectly, to persons in Singapore other than (i) to an institutional investor pursuant to Section 304 of the Securities and Futures Act, Chapter 289 of Singapore (the ‘SFA’) or (ii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA.
For clients and prospects based in Australia: This material is for wholesale clients only and is not intended for distribution to, nor should it be relied upon by, retail clients. Both Insight Investment Management (Global) Limited and Pareto Investment Management Limited are exempt from the requirement to hold an Australian financial services licence under the Corporations Act 2001 in respect of the financial services; and both are authorised and regulated by the Financial Conduct Authority (FCA) under UK laws, which differ from Australian laws. If this document is used or distributed in Australia, it is issued by Insight Investment Australia Pty Ltd (ABN 69 076 812 381, AFS License No. 230541) located at Level 2, 1-7 Bligh Street, Sydney, NSW 2000.
© 2017 Insight Investment. All rights reserved.
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IMPORTANT INFORMATION
Risk Disclosures
Investment in any strategy involves a risk of loss which may partly be due to exchange rate fluctuations.
ASSOCIATED INVESTMENT RISKS
Currency hedging techniques aim to eliminate the effects of changes in the exchange rate between the currency of the underlying investments and the base currency (i.e. the reporting currency) of the portfolio. These techniques may not eliminate all the currency risk.
Derivatives may be used to generate returns as well as to reduce costs and/or the overall risk of the portfolio. Using derivatives can involve a higher level of risk. A small movement in the price of an underlying investment may result in a disproportionately large movement in the price of the derivative investment.
Investments in emerging markets can be less liquid and riskier than more developed markets and difficulties in accounting, dealing, settlement and custody may arise.
Investments in bonds are affected by interest rates and inflation trends which may affect the value of the portfolio.
Where leverage is used through the use of swaps and other derivative instruments, this can increase the overall volatility. Any event that adversely affects the value of an investment would be magnified if leverage is employed by the portfolio and losses would be greater than if leverage were not employed.
