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  • 1. Currency Management in Equity Portfolios May 2006 White Paper Series
  • 2. UBS Global Asset Management White Paper Series This article is taken from UBS Global Asset Management's White Paper Series, dedicated to providing in-depth, innovative investment research. In addition to research on specific asset classes, sectors and regions, we conduct studies of broader strategic issues, and other investment-related topics that help advance the intellectual foundation of our industry. The White Paper Series is an integral part of Global Investment Solutions (GIS). GIS helps UBS Global Asset Management maintain its position as a leading solu- tions provider for institutional and private clients, building on our strength and expertise in the areas of asset allocation and risk management. GIS offers a range of solutions for clients' investment needs, including asset and liability modeling; strategic and active asset allocation; risk management; portfolio management; and education and training.
  • 3. May 2006 Currency Management in Equity Portfolios Introduction contracts are required to bring the currency exposure back to neutral (i.e. to benchmark). We refer to this as the At UBS Global Asset Management our approach to currency “hedge” in this paper. The second step is to work out what management has always been to split apart the decisions forwards are required to achieve the currency exposures rel- about which assets should be incorporated into a portfolio ative to benchmark that are desired by the return-seeking and what the currency exposure should be. strategy. We refer to this as the “strategy” in this paper. The existence of a deep and liquid market in forward for- Bundling these two groups of forward contracts together eign exchange makes this possible. The currency impact gives us the set of forward contracts that is actually imple- resulting from the purchase (or sale) of an asset can be fully mented in the portfolio. offset by selling (or buying) currencies corresponding to the Table (1) shows a simple example of this. Column A con- currency exposure of the asset back into the base currency. tains the currency exposure of the benchmark of an equity In the case of government bond markets, the currency portfolio, and column B contains the currency exposure of exposure of the asset in question is straightforward, as it is the portfolio of equities as it is currently invested. In this 100% of the currency of denomination. In the case of equi- example, we are not pre-assuming how columns A and B ty markets, measuring currency exposure is not so clear cut. have been worked out, since that is the subject of the Many companies are global, operating in many different analysis in this paper. The percentages in column C are the currency zones. The currency in which its shares are denomi- "hedge"—the forward currency exposures that are required nated may bear little relation to the markets in which the to get the currency exposure resulting from the asset strate- company operates. Even if a company is based solely in one gy B—once we know what it is—back to benchmark A. country, it may have considerable exposure to foreign cur- Once we have a method for determining the numbers in rencies by virtue of sales abroad or imports of components columns A and B, then the numbers in column C are given. and raw materials. Column D shows what the currency "strategy" is: the cur- In this paper we acknowledge that consensus wisdom on rency exposures relative to benchmark that are desired in a the currency exposure of equities is subject to more variable return-seeking context. Finally, column E shows the net set opinion, and we examine the best approach to currency of forward currency exposures that has to be implemented management in equity portfolios. We consider altogether in order to achieve currency strategy D starting from under- five approaches. Our conclusion is that the most effective lying exposures B. These numbers in D and E are also approach is to assume that the currency exposure of the known once we have determined A and B. equity is equal to 100% of its currency of denomination (as The point here is that we need to measure A and B before in the case of government bonds). This is consistent with we can effectively carry out currency management on this the approach taken at UBS Global Asset Management. equity portfolio—even if we "already know" what desired currency strategy D we want. Two-step currency management: “Hedging” and Note that when we measure the performance of currency “Strategy” strategy, we examine exclusively the performance of the The construction of a return-seeking currency overlay on a position represented by column D, not the total set of for- portfolio involves a conceptual two-stage process, even ward contracts in column E. The performance of the under- though there is only one stage in implementation. The first lying strategy is equal to the total portfolio performance less step in constructing the overlay is to work out what forward the performance of the currency strategy. That is – the per- Table 1: Example of construction of currency overlay C E A B (A-B) D (C+D) Currency exposure resulting Forwards required Net set from asset to neutralize of contracts Benchmark asset strategy currency Currency to be 1 weights (%) (%) exposure1 strategy1 implemented USD 40 30 +10 -5 +5 EUR 30 35 -5 -5 -10 JPY 30 35 -5 +10 +5 1 Percent of portfolio. © 2006 UBS Global Asset Management (Americas) Inc. is a subsidiary of UBS AG - All rights reserved.reserved. 1
  • 4. Currency Management in Equity Portfolios May 2006 formance of the assets held, with their currency exposure Candidate methods of hedging currency risk of neutralized back to benchmark (by whatever method is cho- equities sen to do this). [1] No hedge In this paper we are focusing exclusively on the first part of With the first method, no hedge is applied. The assumption the process—namely, how we estimate currency exposures underlying this is that there is no way to come up with cur- A and B. rency exposures on a forward-looking basis; therefore, there is no hedging method to reduce currency risk, and the Determining the best hedge for equity portfolios hedge is simply to do nothing. This method serves as a benchmark to judge if other methods are superior. The issue here is therefore how we identify the currency exposures in columns A and B in table 1 on the preceding [2] Nominal hedge page—where the underlying portfolio is an equity portfolio. With this method, currency exposure is assumed to be The hedge (column C) is the difference between A and B. 100% of the denomination of listing2. As mentioned in the introduction, for some asset classes, [3] Foreign sales hedge such as government bonds, this is a trivial exercise since the currency exposure is simply 100% of the currency in which In this method, foreign sales data are used to obtain a proxy the asset is denominated. But for equity portfolios, the true for currency exposures, and the assumption is that foreign currency exposure is less clear. A company may operate in sales determine the true currency exposure of the equity. many different currency zones than the one in which its Since foreign sales data are relatively stable over time, one shares are listed. For example, Nestlé is listed on the Swiss can apply last year’s figures for the current year. A problem stock exchange and its shares denominated in CHF, but only with this is that detailed, company-specific breakdowns of a comparatively small proportion of its activities are based in foreign sales are not widely available, although the propor- Switzerland. Although payment for the shares would be tion of a company’s sales coming from outside its domestic made in CHF, it could be misleading to think that the asset location is available. Therefore, we break down the foreign bought had a high exposure to the CHF. In fact, Nestlé’s portion of sales according to the trade statistics of the coun- share price, when measured in CHF, can exhibit a positive try where the company’s headquarters is located. The for- correlation with the USDCHF exchange rate, reflecting the eign sales concept is perhaps intuitively superior in an era of fact that much of the company’s activities take place in the globalisation, although it is probably mitigated in practice by US. internal corporate hedging, which is not generally disclosed to the market Even if a company is based solely in one country, it may well be exposed to foreign exchange rate movements by virtue [4] Regional exposure hedge of foreign sales or foreign imports. This method is similar to the foreign sales method, but Given all the above, it is clearly not necessarily the case that makes use of region exposures of stocks. The UBS Global the currency exposure of an equity should be purely the cur- Asset Management equity risk model already applies region- rency where the firm is located at all times. al exposures to stocks, which are estimated simultaneously with industry and size effects when the risk model is set. It Nonetheless, we require a consistent and operationally effi- is possible to transform these region exposures into currency cient method, driven by an underlying set of assumptions, exposures. The four regions are North America (assigned to to make a conclusion about what the currency exposure in 100% USD), Europe (100% EUR), Asia (100% JPY) and equity portfolios is—and consequently a conclusion about Emerging Markets (a third each USD, JPY and EUR). This what the best hedge of that currency exposure will be. If no concept also has intuitive appeal, similar to the foreign single method is always guaranteed to be correct, we need sales-based currency exposure concept. to find the best feasible method. [5] Regression hedge To address this issue, we compared five approaches to the hedging of currency risk in equity portfolios, with each This method uses a backward-looking regression to inform method embodying different assumptions about what the us of what the implied currency exposures of an equity is. currency exposure of equities should be. Using the previous year’s data, the stocks’ local returns are regressed onto its local currency exchange rates versus the three major currencies USD, JPY and EUR. This yields a stock’s realized currency exposure in USD, JPY, EUR and the currency in which the stock is denominated. If we assume 2 In this study if the shares were listed in more than one currency, the location of headquarters was taken to determine currency denomination. 4 © UBS Global Asset Management (Americas) Inc. is a subsidiary of UBS AG - All rights reserved.reserved.
  • 5. May 2006 Currency Management in Equity Portfolios that the currency exposure is stable, and that the historic methods showed that method 2 is empirically the most sat- regression is a good forward-looking guide, then this isfactory method of hedging currency risk. In other words, method has empirical appeal. nominal hedging—assuming that the foreign exchange exposure of equity is that of its listing currency—is the most effective way to remove currency risk from the portfolio, Analysis of hedging methods and this assumption is the most valid general assumption to We compared empirically how effective each of the five make about the currency exposure of equities. methods is in removing the currency risk of equity holdings. Methods 3 and 4 are approximately as effective as method This was done by systematically applying the method of 2, but not quite. However, methods 3 and 4 would be hedging to various universes of global equities—such as the viable alternatives to method 2 if they were superior in top 1500 stocks by year 2004 market capitalisation, and so other ways. on. In fact, the operational difficulty (and operational risk) of The logic underlying the analysis is as follows: if the select- methods 3 and 4 is somewhat greater than method 2. ed method is highly effective at removing currency risk from Difficulties arise in the following ways: equity portfolios, then it follows that the assumptions behind that method are highly accurate ones to make about If the currency exposure is assumed to be different from what the true currency exposures of equities are. If a the listing currency of a stock, appropriate measurement method is less effective—it fails to remove much currency technology needs to be in place so that hedging amounts risk—then the assumptions behind it do not so accurately can be determined. define the true currency exposure of equities. By this logic, Reporting of portfolio exposure to underlying investors those assumptions behind the method which takes out the and other interested parties is based on nominal (listing most currency risk should be the best assumptions for how currency) exposure, generally industry wide. If we were to estimate currency exposure of equities. not treating the foreign exchange exposure of stocks as The means of measuring how much currency risk remains in being their listing currency exposure, reporting technolo- a hedged equity holding is to regress the returns of that gy that communicated this fact would need to be devel- equity (ex-post the chosen hedging method) onto the oped. exchange rates of the JPY, EUR and USD (three currencies, Performance attribution of portfolios separately accounts therefore two independent exchange rates) and the respec- for currency exposure, and its effect on performance and tive local currency of the stock (one additional exchange this methodology (Singer-Karnosky) also assumes that any rate if the local currency is none of USD, EUR and JPY). The security’s currency exposure is that of its listing currency. result of this regression informs us whether foreign If we switched to a different assumption, performance exchange risk has been removed or remains: The greater the attribution philosophy and methodology would need to extent to which exchange rate movements can explain the reflect that switch in the same way as reporting. hedged equity returns, the worse the hedge is. This gives a measure of comparison across hedging methods. We simu- Methods 1 and 5 are significantly inferior to methods 2, 3 lated this analysis on randomly generated long/short portfo- and 4. Method 5 also attracts the same operational difficul- lios of either 25 or 100 stocks; in addition the analysis was ty issues as methods 3 and 4 above. Method 1 would incur performed on each single stock in the relevant universe. We the two issues of how to report currency exposure and how then amalgamated the results into a population histogram to attribute currency performance. divided into quartiles. For a method that is an effective The conclusion of this exercise is that nominal hedging hedge, the remaining currency risk for the population will is marginally the most superior method from a risk be small, whilst for an ineffective method, it will be higher. management perspective, and significantly superior A comparison of methods should therefore indicate which from an operational perspective. The perceived intu- method is superior. If we cannot improve on an existing itive superiority of methods 3 and 4 may be disregard- method, there is no basis for exploring alternatives further. ed given that they do not appear to produce superior If we can—then the expected improvement under the supe- results. rior alternative would need to be assessed relative to the difficulty of implementing it. Results and conclusion of analysis The results of the analysis are presented in detail in the first appendix on page 6. Here we focus on the major results and conclusions drawn from them. The analysis of these © UBS Global Asset Management (Americas) Inc. is a subsidiary of UBS AG - All rights reserved.reserved. 5
  • 6. Currency Management in Equity Portfolios May 2006 Appendix 1: Detailed risk study portfolios: i.e., 1.95% for those with 25 positions and 1.05% for those with 100 positions. 1. Data Applying a nominal hedge (method 2) reduces the currency The analysis was done using currency and equity return data risk to 1.43% (for long/short portfolios with 25 positions) from 2000 up to 2004. The sample of companies available and 0.77% (for long/short portfolios with 100 positions). included all the stocks within the UBS Global Asset Management equity risk model (about 10,000). We further Methods 3 (foreign sales hedge) and 4 (region exposure segregated this sample into the top 1,500, 500 and 100 hedge) achieve similar results to method 2, though they are stocks according to market capitalization. The results pre- not quite as good. In contrast method 5 (the regression esti- sented in table 2 below pertain to the top 1,500 stocks, mate hedge) performs very poorly and achieves hardly any which are close to the universe of the MSCI World index. reduction in risk compared to the “do nothing” We also show the results based on other strata, including strategy. the full sample set, and on individual stocks in figures 1 to The final column of table 2 shows the local equity market 4. risk, which is included so as to give some measure of the The foreign sales and country data required for method 3 magnitude of currency related risk in relation to overall port- were as at 2004. These data sets are relatively stable over folio risk. Currency risk is approximately 20% of local equity time so employing the figures as at 2004 should not lead to market risk; this can be reduced to approximately 15% by a severe bias favoring this method in 2004 and disfavoring applying a hedging strategy on the lines of method 2. it in 2001, 2002 and 2003. Table 2: Currency risk (% per annum) after applying As mentioned above, estimates of regional exposures (for different hedging approaches method 4) were taken from the UBS Global Asset Management equity risk model. This model was estimated Long/Short 25 No Hedge Nominal Foreign Region Regression Equity on data from 1999 until 2003 but as in the case of the for- Hedge Sales Exposure Estimate Local eign sales, this should not lead to a severe bias. Hedge Hedge Hedge Risk For the regression estimates (method 5) we estimated cur- 2001 2.30 1.63 1.82 1.90 2.06 12.1 2002 2.12 1.64 1.77 1.78 1.74 10.9 rency exposures each year and then applied these to com- 2003 1.85 1.48 1.50 1.48 1.81 10.7 panies in the following year. For the purpose of this exercise 2004 1.53 0.96 1.02 1.17 1.39 8.2 Mean 1.95 1.43 1.53 1.58 1.75 10.5 only the three major currencies—USD, JPY and EUR—plus the base currency were included as regression co-efficients. Long/Short 100 No Hegde Nominal Foreign Region Regression Equity Including more currencies than this would have increased Hedge Sales Exposure Estimate Local the risk of picking up other (noncurrency related) effects. Hedge Hedge Hedge Risk 2. Long/short portfolio construction 2001 1.21 0.85 0.90 0.89 1.19 6.2 2002 1.22 0.90 0.96 0.97 0.93 5.6 The results presented below were based on randomly sam- 2003 0.96 0.80 0.74 0.77 0.92 5.3 2004 0.81 0.54 0.58 0.61 0.75 4.2 pled long/short portfolios. Over 100 long/short portfolios Mean 1.05 0.77 0.80 0.81 0.95 5.3 were generated containing 25 long and short positions Figures refer to median value over 100 randomly generated portfolios. each; a further set of over 100 portfolios was generated Universe consists of top 1,500 stocks in terms of market capitalization each containing 100 long and short positions. For the long/short portfolios with 100 active positions, the In Figure 1 on the following page, the top two panels show sizes of the positions were similar to a well-diversified global the currency risk from Table 1 in a graph. The bottom two equity strategy with a risk relative to its benchmark of ca. panels are the corresponding figures for the smaller universe 5%. For these portfolios the estimation error is small, and, of the top 500 stocks in market capitalization with no sub- therefore, the forecasting errors are mainly due to the stantial difference in pattern. A logarithmic scale is used. change in the currency exposures and not due to estimation error. For the long/short portfolios with 25 active positions, Figure 2 on the following page graphs the currency risks for the size of the positions is similar to a concentrated global individual stocks. Whereas for long/short portfolios and equity strategy with a relative risk of ca. 10%. hedged individual stocks the currency risk is independent from the base currency, this is no longer the case for non- 3. Results hedged individual stocks, and the risk numbers shown in Table 2 below shows the median currency risk after applying this case are relative to the USD. the different hedging methods. The “No Hedge” column refers to method 1 (the “do nothing” strategy), and, there- fore, gives an indication of the currency risk in long/short 6 © UBS Global Asset Management (Americas) Inc. is a subsidiary of UBS AG - All rights reserved.reserved.
  • 7. May 2006 Currency Management in Equity Portfolios Figure 1: Long/short portfolios Median currency risk of random portfolios with holdings from selected universes top 1500 mkt 25 long/short top 1500 mkt 00 long/short top 500 mkt cap 25 long/short top 500 mkt cap 100 long/short Figure 2: Individual stocks Median currency risk (vs. USD) across selected universes factor universe top 1500 mkt cap top 500 mkt cap top 100 mkt cap © UBS Global Asset Management (Americas) Inc. is a subsidiary of UBS AG - All rights reserved.reserved. 7
  • 8. Currency Management in Equity Portfolios May 2006 4. Detailed results 2004 Note that in these charts, “unh” = method 1, “nom” = For the year 2004, Figures 3 and 4 below and on page 9 method 2, “fsa” = method 3, “reg” = method 4, and “est” show the distribution of currency risk across either a select- = method 5. ed stock universe or across the 100 randomly created The qualitative assessment of the different hedging methods long/short portfolios. The blue box indicates the 1st quartile comes to the same conclusion as if looking only at the (lower border) and the 3rd quartile (upper border), the median values. The pattern for the 2001, 2002 and 2003 median (red line within the blue box), the extent of the data data is basically the same and therefore has not been range (black line), and possible outliers that go beyond 1.5 included here. inter-quartile ranges (red 'plus' signs outside the box). Figure 3: Long/short portfolios Median currency risk of random portfolios with holdings from selected universes 2004 top 1500 mkt 25 long/short 2004 top 1500 mkt 100 long/short -1 -1 10 10 currency risk -2 -2 10 10 -3 -3 10 10 unh nom f sa reg est unh nom f sa reg est 2004 top 500 mkt cap 25 long/short 2004 top 500 mkt cap 100 long/short -1 -1 10 10 currency risk -2 -2 10 10 -3 -3 10 10 unh nom f sa reg est unh nom f sa reg est 8 © UBS Global Asset Management (Americas) Inc. is a subsidiary of UBS AG - All rights reserved.reserved.
  • 9. May 2006 Currency Management in Equity Portfolios Figure 4: Individual stocks Currency risk (in un-hedged case vs. USD) distribution across selected universes 2004 factor universe 2004 top 1500 mkt cap 0 0 10 10 currency risk -1 -1 10 10 -2 -2 10 10 unh nom f sa reg est unh nom f sa reg est 2004 top 500 mkt cap 2004 top 100 mkt cap 0 0 10 10 currency risk -1 -1 10 10 -2 -2 10 10 unh nom f sa reg est unh nom f sa reg est Appendix 2: Mechanics of currency overlays ment date. This relationship between the spot and forward rates holds strictly3: assuming no change in the interest rate The implementation of a currency overlay on a portfolio differential between the two currencies, any change in the involves the use of forward currency contracts in order to spot rate will be reflected one for one in a change in the manage currency exposure separately from that of the forward rate. underlying assets. A brief example will illustrate how this works. Suppose that a US investor wishes to buy German The interest rate adjustment reflects an arbitrage condition: government bonds but does not wish to gain exposure to a currency with a higher interest rate relative to another the euro (EUR). He can do this by agreeing to sell EUR back must trade at a discount in the forward market (i.e., it is into USD at a future date at the time when he initially buys cheaper to buy forward than spot) to reflect the fact that it EUR in order to effect his purchase of government bonds. earns a higher interest rate in the intervening period. If this The forward price of EURUSD is fixed in advance and is were not the case it would be possible to earn riskless profit equal to the spot exchange rate (how much USD the by buying the higher-yielding currency in the spot market investor had to pay to get the EUR required for his German and simultaneously selling it in the forward market. bond purchase), adjusted by the interest rate differential. Conceptually, a combined spot purchase and forward sale This relationship can be expressed algebraically as: of a foreign currency is exactly the same as if an investor held on to his domestic currency (placing it on deposit) and (+ ) US e = e • (+ r 1 borrowed the foreign currency in order to effect his pur- f s 1 r ) EU chase. Thus, there is no currency risk but there is a gain or loss involved equal to the interest rate differential between where ef is the forward EURUSD exchange rate (expressed the two currencies. as US dollars per euro), es is the spot EURUSD exchange When settlement of the forward contract is due, an investor rate; rUS and rEU are the nominal interest rates in US dollars can maintain his currency hedge by performing a spot trans- and euro, respectively, applicable for the time period action to settle the forward trade and simultaneously enter- between the forward settlement date and the spot settle- ing into another forward trade at a later date. Consider the 3 Technically it is known as covered interest rate parity. © UBS Global Asset Management (Americas) Inc. is a subsidiary of UBS AG - All rights reserved.reserved. 9
  • 10. Currency Management in Equity Portfolios May 2006 example of the US investor who buys German bonds and then hedges the currency exposure by selling EUR forward back into USD. Imagine he had originally implemented this currency hedge at time S0 for settlement date S1. When date S1 is reached our US investor can maintain his currency hedge by buying EURUSD to settle the original forward sale and simultaneously selling EURUSD again at a later date S2 (see diagram (1)). This is often referred to as rolling a for- ward contract. Diagram 1: Illustration of rolling a forward foreign exchange contract Sale of EURUSD for settlement at time S2 Sale of EURUSD for settlement at time S1 Purchase of EURUSD for settlement at time S1 S0 S1 time S2 10 © UBS Global Asset Management (Americas) Inc. is a subsidiary of UBS AG - All rights reserved.reserved.
  • 11. May 2006 Currency Management in Equity Portfolios Previously published papers in the White Paper Series include: Aaron Meder. "Slaying the pension (deficit) dragon.” UBS Global Asset Management, September 2005. Renato Staub. "Top-down modeling of a market covariance matrix.” UBS Global Asset Management, May 2005. Renato Staub. "Capital Market Assumptions." UBS Global Asset Management, February 2005. Renato Staub. “Asset Allocation vs. Security Selection—Baseball with Pitchers Only?” UBS Global Asset Management, November 2004. Edwin Denson. “Dynamic Alpha Strategy.” UBS Global Asset Management, September 2004. Tom Clarke. “Market Behaviour Analysis.” UBS Global Asset Management, August 2004. Tom Clarke and Jonathan Davies. “Active Currency Management, Mean Reversion and Trading Rules.” UBS Global Asset Management, June 2004. Brian Singer. “Asset Allocation Revival.” UBS Global Asset Management, March 2004. Brian Singer, Renato Staub and Kevin Terhaar. "An Appropriate Policy Allocation for Alternative Investments." Journal of Portfolio Management, Spring 2003. Renato Staub and Jeffrey Diermeier. "Segmentation, Illiquidity and Returns."Journal of Investment Management, First Quarter 2003. Author: Tom Clarke Managing Director, Global Investment Solutions Tel. +44-20-790 15551 Jonathan Davies Executive Director, Global Investment Solutions Tel. +44-20-790 15117 Günter Scharz, Ph.D. Executive Director, Global Investment Solutions Tel. +41-44-235 4706 To request any of our white papers, please contact: April Powell Tel. +1-312-525 7792 © UBS Global Asset Management (Americas) Inc. is a subsidiary of UBS AG - All rights reserved.reserved. 11
  • 12. This publication is intended for limited distribution to clients and associates of UBS Global Asset Management. Use or distribution by any other person is prohibited. Copying or distributing any part of this publication without the written permission of UBS Global Asset Management is prohibited. Past performance is no guarantee of future results. The information and opinions contained in this document have been compiled or arrived at based upon informa- tion obtained from sources believed to be reliable and in good faith. All such infor- mation and opinions are subject to change without notice and this document is for information purposes only. It is not intended to be construed as an offer or a solici- tation to buy or sell any securities. A number of the comments in this document are based on current expectations and are considered “forward-looking state- ments.” Actual future results, however, may prove to be different from expecta- tions. The opinions expressed are a reflection of UBS Global Asset Management’s best judgment at the time this report is compiled, and any obligation to update or alter forward-looking statements as a result of new information, future events, or otherwise is disclaimed. UBS AG and/or its affiliates may have a position in and may make a purchase and/or sale of any of the securities or other financial instru- ments mentioned in this document. 2006 by UBS Global Asset Management (Americas) Inc. UBS Global Asset Management is a business group of UBS AG. In the United C6-0303 05/06 States, it provides investment advisory services through UBS Global Asset Management (Americas) Inc. and UBS Global Asset Management Trust Company.