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Dynamic Currency Hedging


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Dynamic Currency Hedging
- by Lloyd Alty, Head of Currency, Macquarie Bank

Published in: Economy & Finance, Business
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Dynamic Currency Hedging

  1. 1. Macquarie FICCAM – Dynamic Currency Hedging March 2010
  2. 2. 2 Accurate forecasting is near impossible > Forecasting the future direction and magnitude of currency moves is very difficult. > 8 out of 14 years, expert forecasts misstheactual rate by more than 10%. > In many years experts get the direction of the currency move completely wrong (like in 2008) Source: Macquarie A professional currency manager will provide full hedging servicesto protect your overseasassets. -30 -20 -10 0 10 20 30 1996 1998 2000 2002 2004 2006 2008 0.4 0.5 0.6 0.7 0.8 0.9 1 % missed in forecast (LHS) AUD/USD (RHS) % $
  3. 3. 3 The high cost of wrong direction > During the second half of 2008, the cost of having the wrong strategy (hedged) versus those with the right strategy (unhedged) was 34%. > A wrong hedging strategy may bring a top performing company to the bottomof the peer group. > There is a high correlation between periods of AUD depreciation and fall in asset value which makes a wrong decision very costly and unmanageable. - What happens if your assets are illiquid? - How do you finance the drawdowns? 34% Can you leave a 34%fall unmanaged? Source: Bloomberg. The results are calculated based on a MSCI currency basket from July 2008 to October 2008 Hedgeyour overseasassetsand choosethe appropriatehedging solution
  4. 4. 4 Static hedge Profit Loss AUD/Basket Down AUD/Basket Up If you fully hedge, the P/L effect due to currency is neutralised. HEDGE GAIN HEDGE LOSS
  5. 5. 5 The perfect hedge Profit Loss > If you do not hedge, the P/L effect due to currency is maximised. HEDGE GAIN NOHEDGE AUD/Basket Down AUD/Basket Up > Ideally you want to fully hedge when the base currency goes up and have no hedge when the base currency goes down.
  6. 6. 6 Dynamic Currency Hedging, the ultimate hedge Profit Loss A similar profile to the perfect hedge. HIGH HEDGE LOW HEDGE AUD/Basket Down AUD/Basket Up
  7. 7. 7 What is Dynamic Currency Hedging (DCH)? > DCH is a systematic trend following strategy with limited amount of manager discretion. > DCH is a hedging strategy designed to minimise down side currency risk while allowing to participate in the upside gain. > The level of currency hedge changes as exchange rate levels fluctuate. > Aims to achieve an option-like pay off over a 12 month period. > Primarily use currency forward contracts. DCH, theultimatehedge
  8. 8. 8 How does Dynamic Currency Hedging work? AUD/Basket 50 % 25 % 0 % 100 % 75 % If the AUD appreciates, DCH moves towards a hedge level of 100% Hedge Ratio If the AUD depreciates, DCH moves towards a 0% hedge level A DCH’s return profile shows gains as the AUD rallies but limits downside losses when the AUD falls Initial hedge
  9. 9. 9 Big hedging losses & illiquid assets Profit Loss When the base currency falls and your forward contracts mature you need cash to pay the loss. > If your assetsareilliquid, this might bedifficult to sell > If your assets have depreciated, it could be the wrong time to sell HEDGE LOSS Unrealised Gain Realised Loss AUD/Basket Down
  10. 10. The AUD as a proxy for world growth 10 Source: Bloomberg, Morgan Stanley.
  11. 11. How DCH performed through the largest AUD fall > The DCH program quickly lowered the hedge level in line with the 40% fall in AUD late last year. > Our disciplined approach means we were on the trend as currency moved. > Drawdownswereminimized 11 0.60 0.65 0.70 0.75 0.80 0.85 0.90 0.95 1.00 Jun-2008 Jul-2008 Aug-2008 Sep-2008 Oct-2008 Nov-2008 Dec-2008 Jan-2009 0% 10% 20% 30% 40% 50% 60% AUD-USD (LHS) Hedge Level on Client Account (RHS)
  12. 12. 12 Statistics 50%hedged DCH Unhedged Fully hedged Total currency return* 17.0% 22.7% 30.4% 3.8% Drawdown (realised loss) -13.5% -7.8% 0.0% -26.6% Drawdown on $100m portfolio -$13.5m -$7.8m $0 -$26.6m Cash management when the AUD falls *Equal to ‘realised return (from hedge) + unrealised (from assets)’ Source: Data taken from the track record of our longest running DCH client (since 1992), AUD versus currency basket. 30 Jun 2008 – 30 Dec 2008 (Period including the largest historical fall in the AUD) > The wrong hedging strategy may bring a top performing company to the bottom of the peer group. > Funding the recent fall in the AUD using a static hedging strategy was very expensive. > DCH significantly reduced the losses on the hedge and hence the need to crystallise asset losses at a time of poor liquidity.
  13. 13. 13 Dynamic Currency Hedging - Summary Dynamic Currency Hedging, theultimatecurrency hedge No need to forecast the currency direction  Limits losses on hedging as the local currency depreciates  Protects the foreign portfolio as the local currency appreciates  The hedging strategy with the best long term performance  Manageable cashflows with one settlement per year  Tailored programs 