A Guide to Currency Overlay Management

"210 %" +(
Contributors
• Carol Parker
InterSec Research Corp.
• Bill Muysken
William M. Mercer
Investment Consulting
• Harriett Richmond
Michael Sager
JPMorgan Fleming Asset
Management
• Adrian F. Lee
Lee Overlay Partners
• Joost van der Kolk
Hoogovens Pension Fund
• Michael Collins
Deutsche Asset
Management
• Neil Record
Record Currency
Management
• Paul F. Duncombe
State Street Global Advisors
• Ronald G. Layard-
Liesching—
Pareto Partners
• Philip Simotas
FX Concepts Corporation
• Ray Dalio—
Bridgewater Associates
February 2002
David Folkerts-Landau
Managing Director, Head of
Deutsche Bank Global
Markets Research
Editor
David Knott
Deutsche Bank Global
Markets Research
A Guide to Currency Overlay Management
GlobalMarketsResearch

210 % +( A Guide to Currency Overlay February 2002
2 Global Markets Research
Table of Contents
Introduction ........................................................................................................................ 3
Summary ............................................................................................................................ 5
The Outlook for International Diversification....................................................................... 8
Currency Myths and Legends........................................................................................... 12
A Consultant’s View of Currency Risk and Overlay .......................................................... 24
Establishing the Currency Risks of a Portfolio .................................................................. 29
Currency Issues Facing International Investors—A Framework for a Solution ................. 32
Currency Overlay Manager Selection ............................................................................... 37
The Mechanics of Currency Overlay................................................................................. 42
Implementing a Currency Overlay Programme................................................................. 47
A Different Way of Looking at Currency Overlay Performance ........................................ 51
Do Currency Managers Add Alpha?.................................................................................. 53
Adding Value Through Active Currency Management ...................................................... 57
The Upcoming Currency Bonanza..................................................................................... 61
Inefficiencies and Opportunities in the Currency Markets................................................ 65
Glossary............................................................................................................................ 69

February 2002 A Guide to Currency Overlay 210 % +(
Global Markets Research 3
Introduction
The spectacular growth in cross-border assets since the beginning of the 1990s has
exposed investors to increased currency risk and consequently the possibility of
losses stemming from adverse currency movements.
At the end of 1995, US$720 billion was invested by global insurance companies in
assets outside their home country. By the end of 2000, this had risen to US$1.34
trillion, with pension-fund assets forecast to grow by 12% per annum between 2000-
2005. In turn, cross-border investments by pension funds will increase by 20%, or to
US$3 trillion, by the end of 2005. As a result, by 2005, one in every five dollars of
pension-fund investments will be cross-border and hence subject to FX risk.
In the past, investors have tended to ignore currency risk and return, believing that
exchange-rate fluctuations tend to wash out over time. In reality, mean reversion in
currencies can take a prolonged period of time to occur, and it is therefore not
prudent to ignore currency risk. The globalisation of investor portfolios, the
introduction of the euro, as well as the various emerging-market crises have all
brought increasing attention to the concept of currency management.
Currency overlay management involves managing the currency exposures in an
investment portfolio separately from the underlying asset exposures. More often than
not, this is conducted by an external currency overlay manager with specific expertise
in currency management. The objective of the currency overlay manager is to attempt
to limit currency losses while participating in currency gains.
Currency overlay is a relatively young business. The first mandates were awarded in
the UK, Japan, the U.S. and continental Europe in 1985, 1987, 1988, and 1992,
respectively. Their popularity has been particularly strong in the U.S., the UK, the
Netherlands, Ireland and Australia, reflecting the highly internationalised
characteristics of these countries’ investment portfolios. However, at the end of 2000
only 11% of U.S. cross-border investments were overlaid, implying considerable
room for growth.
European investors are also moving into the front line of this development due to the
need to increase their allocations to non-Euroland assets to remain adequately
diversified following the introduction of the euro. Moreover, the past five years has
been a currency bonanza for European investors, given the weakness of the euro.
With the U.S. dollar now considered to be significantly overvalued, there is a non-
negligible risk that the dollar might weaken going forward. In such a scenario, it would
be highly prudent for European fund managers to become significantly involved in
managing further FX risk. Currency risk will need to be actively managed both to lock-
in recent currency gains and to maximise currency alpha. (Throughout this report,
reference is made to currency alpha, which relates to the incremental return or out-
performance of the fund with respect to the market index. Reference is also made to
the information ratio, which is the ratio of expected return to risk, as measured by the
standard deviation. Usually, this statistical technique is used to measure a manager's
performance against a benchmark.)
There are different types of approaches to currency overlay, with all active currency
management approaches grounded in either fundamental analysis or technical
analysis, or some combination of the two. Overlay managers often recommend that a
pension fund select more than one external currency overlay approach as a means of
diversifying risk.
This report outlines some of the historical reasons for the neglect of currency, either
as a source of risk or as a source of investment returns. It considers the merits of an
alternative, more active, approach to managing FX risk. We describe a framework that
allows investors to decide how much FX risk they should take, the steps needed to
implement an active currency management (currency overlay) programme, and how
much alpha might be generated.

The unique aspect of this comprehensive guide to the business of actively managing
currency risk is that it contains contributions from many leading lights of the currency
overlay world.
• InterSec Research Corp. report their analysis of the contribution of currency to
the returns of U.S.-based equity portfolios and their predictions for the extent of
cross-border asset flows likely in coming years.
• William M. Mercer Investment Consulting Group offer their views on currency
and the role of currency overlay in international institutional portfolios. They
believe that there is a role for the active management of currency risk.
• JPMorgan Fleming Asset Management highlight the levels within a portfolio
where FX risk is generated and how it should be separated from other sources of
investment risk.
• Lee Overlay Partners describe a framework for how plan sponsors can address
the key currency issues, hedged vs. unhedged, active vs. passive, and who should
manage FX exposure.
• Hoogovens Pension Fund outline why they took the decision to treat currency as
an asset class. They outline their overlay manager selection process.
• Deutsche Asset Management describe the information flows within a currency
overlay programme when undertaken either by the manager of the underlying
assets or by a specialist overlay manager.
• Record Currency Management describe the institutional requirements for a
successful currency overlay programme such as reporting and accounting details.
• State Street Global Advisors outline how clients and consultants can compare
the performance of different managers with different benchmarks and guidelines.
• Pareto Partners explain how currency exposures can be profitably managed from
the prespective of controlling risk rather than generating excess returns
• FX Concepts Corp. explain why it is important for EUR-based international
investors to consider hedging against upcoming USD weakness.
• Bridgewater Associates discuss the inefficiencies of the global currency markets
and their approach to exploiting these inefficiencies via an understanding of
balance of payments principles.
This report draws a number of strong conclusions in this controversial area. Currently
the most common approach to currency within institutional portfolios is neglect. This
report concludes that both investors and plan sponsors should consider increasing
their focus on both the risk of, and the potential returns from FX. Historical
performance data suggest that active management of FX risk can significantly
increase alpha. The real test for the overlay industry is to demonstrate that this is
sustainable in the future.
The reader will notice that there are a number of issues addressed in this report—
such as whether currencies should be hedged, whether active management is
worthwhile, and whether currencies diversify risk—where individual contributors hold
opposite views. This guide will have achieved its objective if it assists the readers in
drawing their own conclusions.
Michael Lewis (44) 207 545-2166
David Knott (353) 1269-8850
Deutsche Bank Global Markets Research

Summary
While most investors and plan sponsors are comfortable with investment risk in cash,
bonds, property, commodities, domestic equities and foreign equities, far fewer are
comfortable with currency risk. At first glance this is rather odd given the importance
of currency trading and cross-border investment in the world. According to the BIS,1
the daily turnover in the world’s currency markets is about US$1.5 trillion a day. This
is about 30 times larger than the daily turnover of all the world’s equity markets2
and
probably also larger than the turnover in the world’s bond markets. Cross-border
investment flows are also huge. InterSec Research Corp.3
estimate that the world’s
pension assets total US$12.2 trillion, and of this, just over US$2 trillion is currently
cross-border investment. In the section The Outlook for International Diversification,
InterSec Research Corp. outlines how the already well-established trend towards
international diversification is set to continue. InterSec Research Corp estimate that
pension fund assets will grow by 8% annually between 2000 and 2005 and that
cross-border investments by pension funds will grow by 12% over the same period.
This means that by 2005, one in every five dollars of pension fund investments will be
cross-border and hence subject to FX risk. The increased focus on cross-border
assets does not seem limited to investors, as corporations too seem intent on
attaining a global reach, and globalisation is, by definition, synonymous with increased
FX risk. This seems to suggest that there is likely to be an inexorable trend increase in
the significance of currency risk across all business sectors and types of investors.
After all, when investors buy international assets, they have to take a view on how to
handle the FX risk that they have also bought.
While the importance of currency risk is on a sharp up-trend, there has been
surprisingly little discussion about re-evaluating the status of FX risk within
institutional investment portfolios. Indeed, it is still common to read that currency is
not an asset class, that FX is a zero-sum game unlike other asset classes, that FX is
only a source of risk and not a source of return, and that FX risk should be managed
passively (either 100% hedged or 100% unhedged). If large parts of this view were
true, it would mean that currency overlay—the process by which FX exposures are
actively managed—would be pretty much a waste of time.
This report seeks to establish how reasonable these sorts of opinions are. In
Currency Myths and Legends we begin with a brief review of established thinking in
these areas, and what recent evidence and analysis has come to light that has cast
doubt on some of these established precepts.
This chapter concludes that the basis for the lack of interest in FX results from the
view that FX is not an asset class, has no long-term return, but does have significant
risk. This section outlines possible definitions of an asset class and finds that FX
satisfies many of them. Furthermore, it shows that even if FX has no long-term
return, it might take five years or more for that to be demonstrated. In the intervening
period a fund might suffer significant losses. FX volatility accounts for a large
percentage of the volatility of returns from international bonds and equities.
If FX risk needs to be managed, funds need to know how much to hedge and how
much to leave open. The academic view of currency hedging is that one hedge ratio
fits all. The practical approach to hedging suggests that 50% hedging should be used
to minimise regret. Mean/variance analysis is usually used to justify a hedge ratio
other than this.
The two main theories assumed to hold when dealing with exchange rates are
purchasing power parity (PPP) and uncovered interest parity (UIP). These two
assumptions are standard in most theoretical macro economic models. We review
the empirical literature covering tests of these theories and find that there is weak
1
Central Bank Summary of Foreign Exchange and Derivatives Market Activity, BIS, May 1999.
2
Reported in Lindahl, Investment and Pensions Europe, September 1999.
3
The Pension World at Work: Past, Present and Future, Intersec Research Corp., April 2001.
Cross-border investments
continue to grow. These
generate FX risk
but the status of FX risk
has not evolved
commensurately
FX risk, if treated the
same as other sources of
risk, may be a major
source of investment
returns

support for these theories at best for time periods less than three years. If these
theories do not hold, or work only in the very long run, there is little excuse to ignore
FX risk.
The speed at which attitudes towards currency change amongst institutional
investors will be heavily influenced by the views of investment consultants. Not many
years ago, it was common for consultants to argue that FX exposures could
reasonably be ignored. Fewer and fewer still take this line after a number of years
where poor FX returns have been a key force behind unsatisfactory investment
returns. In the section A Consultant’s View of Currency Risk and Overlay, William M.
Mercer Investment Consulting Group outline their view of the status of currency risk
and their view of currency overlay. They consider that a certain degree of unhedged
currency exposure is worthwhile in a portfolio because of the low level of correlation
of FX returns and other asset returns. Beyond a certain level, however, this
diversification effect is offset by the higher volatility of currency returns. Mercer argue
that active management of an unhedged exposure should be able to add more value
than a passive exposure.
In the section—Establishing the Currency Risks of a Portfolio, JPMorgan Fleming
Asset Management outline the levels at which currency risk needs to be separated
out from the other financial risks within an institutional portfolio. Many investors still
fail to consider FX as a separate source of risk. The key risk control issue is the
separation of currency risk at the policy or benchmark level, as they consider that
passive currency exposure adds no theoretical long-term return to portfolios, but it
does add risk. Better control of currency risk may allow investors to assume
additional risk in other asset classes. At the tactical level, currency risk can be
separated from the underlying asset allocation. There is little reason to hold the JPY
just because of an overweight in Japanese equities. Finally, they argue that at the
decision-making level, there is little reason to believe that investors who excel at
stock picking will also excel at currency management.
Once the decision is taken to separate currency risk at the strategic level, it is
necessary to identify how much currency risk should be taken and how much should
be hedged. Lee Overlay partners, in the section Currency Issues Facing International
Investors – A Framework for a Solution, explain how to calculate this hedge ratio.
An alternative approach at the strategic level is to acknowledge the points made in
the section Currency Myths and Legends, and treat currency risk as a separate asset
class. In this case, the optimal hedge ratio calculation is less important than a decision
as to how much value at risk should be placed in the portfolio. In the section
Currency Overlay Manager Selection, Hoogovens pension fund explain that they
decided to adopt currency as a tactical asset class. Also described is the process by
which Hoogovens selected overlay managers to run their portfolio.
Once a decision has been made as to how much to hedge, a decision will be made as
to whether the unhedged portion will be actively managed or not—whether a
currency overlay programme will be implemented. This raises questions as to how to
set up a currency overlay programme and how it operates.
In the section—The Mechanics of Currency Overlay, Deutsche Asset Management
explain how, once a strategic exposure to FX has been determined, it can be
implemented either actively or passively. This section explains the procedures behind
each approach and discusses their advantages and disadvantages.
In Implementing a Currency Overlay Programme, Record Currency Management
consider the implementation issues of a currency overlay programme. For many plan
sponsors, these operational issues often assume as much importance as some of the
more theoretical issues raised elsewhere in this guide. These range from establishing
lines of credit from banks to fund cash shortfalls from currency hedging, agreeing
reporting arrangements, deal confirmation and reconciliation procedures, the overlay
valuation source data and calculation methodology and the mechanics and delivery of
international asset valuations.
Investment consultants
have a big impact on the
speed at which
perceptions about FX
change.
Currency risk should be
separated from the other
investment risks within
an international portfolio.
Calculating optimal hedge
ratios involves significant
effort by the plan
sponsor.
Or currency can just be
treated as an asset class
directly.
We explain the
information flows behind
a currency overlay
strategy
We explain how to
implement a currency
overlay strategy

Part of the decision to implement a currency overlay programme will be selection of
the managers to undertake the currency overlay. The existing universe of currency
overlay managers can be broken down into passive hedgers, risk reducers and return
enhancers. Passive hedging is essentially an administrative function and hence the
market leaders in this field will be the lowest cost, most efficient service providers.
Risk reducers begin from the premise that it is not possible to generate positive alpha
from the management of currency risk, but it is possible to reduce risk. Return
enhancers tend to adopt either a fundamental approach or adopt a model-driven
investment process.
Due to the differences in style on the part of many overlay managers, it is often
difficult to compare their performance. In the section “A Different Way of Looking at
Currency Overlay Performance”, State Street Global Advisors explain how to
compare the performance of managers with different benchmarks and guidelines.
We are extremely fortunate to have a number of investment managers contributing
articles to this report that provide some more detail on their investment strategies
and how they generate profit for their customers. Of course all the fund managers
contributing to this report have their own styles. It is interesting that there is clear
evidence that the returns from these differing styles may not be as highly correlated
as one might suppose. In “Do Currency Managers Add Alpha?”, the available
evidence is presented, suggesting that, taken together, currency overlay managers
have added considerable value in the past. The final three sections outline how a
range of managers plans to generate alpha in the future.
In Adding Value Through Active Currency Management, Pareto partners explain why
they believe that it is possible to add value through active currency management even
though they do not believe that it is possible to forecast currency returns. This
management style attempts to provide more limited downside risk versus upside risk,
while at the same time generating an excess return versus benchmark. This is
achieved by an active, disciplined trading strategy that is heavily influenced by both
the volatility and trend direction of a currency.
Many investment managers consider that it is possible to generate excess returns
from return forecasting (that is, forecasting future spot exchange rates). In The
Upcoming Currency Bonanza, FX Concepts Corp. explain the macro forces behind
the under valuation of the Euro and why they forecast a fall in the value of the U.S.
dollar in coming years. They take a relatively long-term, cyclical view of currency
valuations rather than focusing on the short-term, less predictable changes. The
previously outlined survey of academic research does support the idea that long-term
fundamental analysis of currencies is possible.
In the section Inefficiencies and Opportunities in the Currency Markets, Bridgewater
Associates discuss the inefficiencies that exist in the currency markets and their
approach to identifying active management opportunities through a deep understanding
of balance of payments principles. In their view, inefficiencies arise because of a large
gap in the skill of market participants and the fact that the majority of global currency
transactions are the by-product of other objectives and not initiated solely for the
purpose of maximising return. These inefficiencies present the opportunity for skilled
managers with a disciplined approach to add value. Bridgewater explain how currency
movements are driven by imbalances in a county’s balance of payments. In their
process, they seek to exploit unsustainable pricing anomalies through an understanding
of the interrelationship between currency pricing, interest rates, goods flows, capital
flows and domestic conditions with the purpose of identifying significant
disequilibriums that will produce sustained currency movements.
Many of the contributions to this report disagree with some of the points of view
expressed within it. This report will have served its purpose if it helps the currency
manager identify the areas of greatest contention and broadly outlines the arguments
for and against each point of debate.
David Knott (353) 1269-8850
The investment styles of
the current universe of
currency overlay
managers are outlined
The focus can be on risk
reduction...
...long-term cycles in the
FX market....
...or the inefficiencies in
the FX markets.

The Outlook for International Diversification
Carol Parker
Vice President, Research and Consulting Manager
InterSec Research Corp.
(1) 203 541-3853
There are two main groups of buyers of cross-border assets—pension funds and
insurance companies. This section considers the current size of these two groups of
investors and outlines InterSec Research Corp's. forecast for growth in cross-border
investments (“CBI”). Pension funds will be the main driver of this growth in CBI, and
we conclude that by 2005, about one in every five dollars invested in pension funds
will be invested in cross-border assets.
Insurance Companies
At year-end 2000, global insurance assets were over US$11 trillion. Of this, 12.0%
were invested in cross-border assets. CBI has grown significantly over the last five
years, not only in dollars, but also in the proportion of total insurance assets. At year-
end 1995, US$720 billion, representing 8.4% of global insurance assets, was invested
by insurance companies in assets outside their home country. At year-end 2000, this
number had risen to US$1.340 trillion representing 12% of global insurance assets.
This is despite the largest pool of assets, U.S. insurance assets, which allows only
limited investment outside the U.S. The U.S., Japan, the UK and Germany
represented over 75% of the world’s insurance assets at year-end 2000 and nearly
70% of global CBI by insurance companies.
Cross-Border Insurance Assets
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
US Japan UK Germany Global Total
percent
1995
2000
Source: InterSec Research Corp.
Insurance companies typically hold assets to match their liabilities. As these are
almost always defined in local currency terms, cross-border assets represent a
divergence away from benchmark, and so can usually only be justified in total-return
terms. But this is not the whole story. For example, the U.S. insurance industry is
regulated on the state level. Most state codes limit foreign investment to 3%-6% of
admitted assets. Looking at the proportion of cross-border investment over the last
five years, it seems clear that insurance companies have responded more to the
extraordinary U.S. equity returns than the state code limits. Over the past five years,
CBI by U.S. insurance companies actually declined from US$151.3 billion or 5.2% of
total U.S. insurance assets to US$102.8 billion or 2.6% of total U.S. insurance assets.

Pension Funds
The World’s Cross-Border Pension Assets
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
US JAPAN UK OTHER TOTAL
USDbillion
95
00
05
InterSec estimates that at year-end 2000, the world’s pension fund assets totalled
US$12.2 trillion. We forecast that this will grow to US$18.2 trillion by 2005. The chart
above depicts the current size of the pension fund world’s cross-border assets and
our forecasts for coming years. We forecast that the world’s pension funds will
control cross-border assets totalling well over US$3 trillion by 2005.
Not only do U.S. pension fund assets represent the largest single component of the
world’s pension fund assets, they have also been growing at a very fast rate. The
chart below shows, however, that the share of U.S. cross-border assets has been
rather lower than in other countries.
Cross-Border Pension Fund Assets as a Percentage of Total
0
5
10
15
20
25
30
35
US JAPAN UK OTHER TOTAL
percent
95
00
05
History of Cross-Border Investment by U.S. Tax-Exempts
In 1974, ERISA set the foundation for internationalization of U.S. pension assets by
stipulating that portfolio managers apply a standard of prudent investing by
diversification. At that time, the United States represented 65% of the MSCI World
Index and investment by U.S. pension plans outside of the U.S. was virtually non-
existent. Through most of the 1980s, an extraordinary run of foreign market returns
attracted the attention of U.S. pension plans and decreased the relative market
capitalization of the U.S. in the MSCI World Index.

Sources of Growth: U.S. Tax Exempt Cross-Border Mandates
0
100
200
300
400
500
600
700
800
900
1,000
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
In September 1989, the market capitalization of the U.S. was only 32% of the total
market capitalization of the MSCI World. By this time, international was a broadly
accepted asset class. Yet throughout the late 80s, as many plans made initial
investments, only 3%-4% of pension assets was invested cross-border. Early in the
1990s, plans became determined to make contributions to achieve desired exposure
levels. If the market returns provided the desirable exposure so much the better;
however, if the market failed, then plans would make the necessary new
contributions to achieve desired exposure levels for the plan.
In 1992, US$22 billion flowed into CBI. At year-end 1992, 19% of public pension plan
assets were invested cross-border as compared to less than 1% invested in cross-
border assets at year-end 1989. Through the late 1980s, with a weakening dollar, U.S.
pension plans were not terribly concerned with the risk of investing in non-dollar
assets. 1992 provided a reminder that a strengthening dollar could erode returns.
For each of the years from 1995 through 1998, the SP 500 dramatically
outperformed MSCI EAFE. The cumulative return over these four years was 189% for
the SP versus 45% for MSCI EAFE. For each of the first three years, pension plans
responded by rebalancing from U.S. equity to international equity. By the end of 1998,
nearly 10% of U.S. pension assets was invested cross-border.
At year-end 2000, U.S. pension investment in cross-border assets was over $790
billion or 11% of U.S. pension assets. This number represents the sum of defined
benefit and defined contribution plans. The penetration of CBI is quite different for
each of these. InterSec Research Corp. estimate that CBI within defined contribution
plans is only around 3%. This number has hardly changed over the last years. The
factors influencing defined contribution allocations are, obviously, quite different than
those influencing defined benefit allocations. InterSec Research Corp. estimates that
CBI investment by defined benefit plans is nearly 18%, certainly at, near, or beyond
target allocations for many plans.
Data collected by InterSec Research Corp. confirm that the market for CBI by U.S tax-
exempts is approaching maturity with many plans at or near target levels. From 1993
through 1997, net flow into cross-border mandates by U.S. tax-exempts ranged from
$34 billion to $50 billion. At year-end 1998, we recognized a turning point with a drop
in net flow down to $22 billion. Net flow for 1999 and 2000 remained well below the
mid-1990s levels. The figures reflect sizeable restructurings, terminations and
manager replacements symptomatic of a maturing business.
InterSec Research Corp. forecast that by year-end 2005, U.S. tax-exempt assets will
reach around US$11 trillion. We expect cross-border investment to grow at an
annualized rate of 13.5% to hit US$1.5 trillion as more and more plans move toward
and achieve target allocations.

From the earliest days of U.S tax-exempt overseas investment, currency has been a
real concern for pension funds. These concerns had to be overcome before
international investment became widespread. In the early days, most pension funds
came to the realization that at low levels of international exposure, the impact of
currency on the overall investment program was too small to matter. Also, there was
little need to worry as the U.S. dollar fell from 1985 through 1990.
InterSec Research Corp. has long believed that when plans reached target allocations,
they would be forced to change policy regarding currency exposures. It is not clear
that this has happened as of yet. InterSec Research Corp. began tracking currency
overlay assets under management in the early 1990s. In 1994, only 10%-11% of
cross-border assets was overlaid. Since then, currency overlay assets have increased,
but only in parallel with cross-border assets. At year-end 2000, again only 11% of
cross-border assets were overlaid.

Currency Myths and Legends
David Knott
(353) 1269-8850
Every institutional investor knows that currency has a big impact on investment
returns, yet the management of currency has not always been accorded the same
status as the management of bonds, equities and other types of assets. In the early
90s, the conventional view of FX was that it was not an asset class, but a source of
risk. There were thought to be two ways of dealing with this risk: full hedging or full
exposure. Full hedging was undertaken on the basis that FX risk only increases
portfolio risk with no commensurate increase in return. Full unhedging tended to be
adopted by those who argued that over the long-term, FX exposure is a zero-sum
game and hence FX risk washes out over a number of years, and full hedging has
some unappealing operational cash-flow implications. In the first part of this chapter,
we consider, and reject, this nihilistic view of currency risk management.
In the second part of this chapter, we consider the academic evidence in support of a
number of relatively common assertions made regarding exchange rates. Specifically,
we highlight that although purchasing power parity (PPP) is assumed to hold in almost
all theoretical macroeconomic models, the statistical evidence in support of this
theory is limited. Theoretical macroeconomic models similarly assume uncovered
interest parity (UIP)—the idea that exchange rates adjust to reflect interest
differentials. We outline how the academic research tends to formally reject this
hypothesis.
Currency as an Asset Class
If part of the reason for ignoring FX is that for many years it was not perceived to be
an asset class, it seems worthwhile trying to understand what characteristics define
an asset class and why FX is not deemed to satisfy them.
For many years the definition of an asset class did not seem to be a problem; asset
classes could be defined with reference to the array of available investment
opportunities (domestic and foreign bonds and equities). However, this is rather a
circular definition, and so not very helpful. Interestingly, formal definitions of what
constitutes an asset class are hard to come by, but a few guiding principles seem to
stand out:4
• An asset class has specific institutional characteristics. For example, equities are
the means by which investors own companies and they provide uncertain
dividends and capital gains, and bonds provide a fixed schedule of interest and
principal payments.
• An asset class helps diversify investment portfolios. The returns from each asset
class should not be highly correlated, otherwise the assets in question provide
limited portfolio diversification. True asset classes must provide significant
portfolio diversification.
• An asset class should provide positive long-run returns from passive investment. It
is common to read that equities in the long run always provide the highest total
returns and, therefore, are the most appropriate asset class for long-run
investment. Indeed, most long-run asset/liability management studies assume
long-run return and risk parameters for the individual asset classes. It used to be a
4
See Robert J Greer, What is an Asset Class, Anyway?, The Journal of Portfolio Management,
Winter 1997. While the definition of alternative asset classes in this article has not become standard,
it does explain some of the limitations of the traditional definition of an asset class.

standard argument that because the long-term return from FX is zero, it cannot be
an asset class.
In what follows we analyse each of these assertions and their ongoing relevance to
the definition of an asset class.
The Institutional Characteristics of Assets
In the 60s and 70s, when many issues of investment policy were first being dealt
with, it seemed only reasonable to use existing securities to help define asset
classes. The mere existence of domestic and foreign bonds and equities, as well as
real estate, was a powerful factor in their being considered asset classes. But
because exchange controls remained in place for many investors throughout the 70s,
the issue of FX was only really pertinent from the 80s onwards. Since FX does not
provide a stream of cash flows, nor is it an identifiable security, it is clear that FX
would never be regarded as equivalent to other asset classes using this definition.
But how relevant is this definition of asset classes in an age of derivatives? It is now
possible to define almost any exposure in the form of a security (using standard
derivatives, if they exist, or total-return swaps), so the definition of asset classes in
terms of institutional characteristics seems outdated.
The Diversification of Investment Returns
For four decades, it has been accepted finance theory that portfolios benefit when
the correlation between asset returns is low. Currency scores well using this
definition of an asset class, as the table below shows. The table depicts the
correlation between quarterly returns from U.S. equity, commodities, real estate,
bonds and currency. While correlations need not be stable over time, the table does
suggest that currency exposure provides some diversification.
U.S. Asset-Class Correlations: Quarterly Data June 1978–December 1995
Commodities Real estate SP500 Foreign
Equities
Bonds Currency
Commodities 1
Real estate -3% 1
SP500 -12% 6% 1
Foreign Equities -6% 2% 60% 1
Bonds -19% 18% 40% 37% 1
Currency -31% -11% -1% -34% -24% 1
Source: Robert Greer, Journal of Portfolio Management, Winter 1997
We believe this to be a general phenomenon of FX, that the correlation of returns
from equities and bonds in a currency and the returns from the currency itself have
tended to be quite low in the past.5
Of course this argument cannot be taken too far, as again due to the availability of
derivatives, it is now possible to create any degree of correlation that is desired.
Nevertheless, it is important to stress that currency exposure has, in the past,
provided a significant degree of diversification.
The Long-Run Return of Asset Classes and the Lack of Return from Currencies
In our view, the most persuasive argument made against according currency the
same status as equities, bonds and properties is that currency exposure provides no
long-term return. Another way of stating the same point is that it does not matter in
which currency you hold your cash, because passive investment strategies yield the
same whatever the chosen currency. Currency is not an asset class, and can be
ignored, because the effects of currency always wash out over time.
In an academic context, the idea that currency returns wash out is framed as a
condition known as uncovered interest parity (UIP). This condition states that the rate
5
Similar results are available for EUR(DEM) and JPY where the correlations between currency and
equities and bonds are (-55%,4%) for EUR(DEM) and (-37%,-8%) for JPY since 1989.

of change of an exchange rate is equal to the interest differential between the two
currencies underlying the exchange rate. It is worth noting that theoretical
macroeconomic models almost always assume that UIP does hold; the rate of
change of the exchange rate in a two-country model is, in equilibrium, equal to the
interest-rate differential.
Let us assume that UIP is a good description of how exchange rates are determined
in the real world, given the importance that academics attach to this rule. (We relax
this assumption later in the section.) The key issue for investors is then the extent to
which deviations occur from UIP. To illustrate this we show in the table below the
returns over five and 10 years from investing in a rolling three-month deposit in
EUR(DEM), USD and JPY from the perspective of an EUR(DEM), USD and JPY
investor. The returns from investing in the foreign currency and assuming exchange-
rate risk are shown as excess returns versus the local currency. Although many of
these excess returns are large in absolute terms, none are statistically significantly
different from zero, providing some support for UIP. The table also suggests that over
the longer term, interest differentials do begin to compensate for currency
movements, since the deviations from UIP over a 10-year period have been much
smaller than the deviations over a five-year period. Stated another way, these results
support the idea that UIP holds, but it seems most useful as a long-run concept.6
Indeed, given the size of the deviations, one wonders how much of a useful concept
it is for managing exchange-rate risk for anything other than the very long run.
Unhedged Annualised Currency Returns
5 years Local Currency Return Excess return in
USD
Excess return in
EUR(DEM)
Excess return in
JPY
USD 567 bp 0 -908 bp -686 bp
EUR(DEM) 365 bp 908 bp 0 276 bp
JPY 41 bp 686 bp -276 bp 0
10 years Local Currency Return Excess return in
USD
Excess return in
EUR(DEM)
Excess return in
JPY
USD 519 bp 0 -157 bp -175 bp
EUR(DEM) 515 bp 157 bp 0 39 bp
JPY 169 bp 175 bp -39 bp 0
Source: DB Global Markets Research
The above data lie behind assertions that passive exposure to FX increases risk with
no commensurate increase in return—the potential excess returns are very large but
not statistically significant because currencies have been so volatile. But the data also
suggest that over shorter periods of time, say five years, it is likely that interest parity
does not hold; in other words, for quite long periods, FX rates may not be mean
reverting. Indeed, it would be no comfort for investors, who have experienced the
large losses from the DEM and then the EUR over the last five years, to know that
chances are that they might revert back to profit over the next five years. The size of
the short-term losses could easily swamp any thoughts about long-term equilibrium.
Of course, what matters most for investors is not the return from cash deposits, but
the return from foreign bonds and equities adjusted for currency. The chart below
depicts the return and risk since 1991 of hedged and unhedged exposure to foreign
bonds and equities. It generally supports the idea that passive, unhedged currency
exposure adds to risk, not to return.
The time period for the analysis is again critical, as it was in the case of the returns
from short-term deposits. If the analysis had been undertaken for a five-year period,
the results would have been quite different. For example, from a U.S. perspective,
over the last five years, unhedged exposure to foreign assets would have generated a
worse return with more risk than hedged exposure on account of the strength of the
dollar over this period.
6
Another way of saying the same thing is that the forward exchange rate is an unbiased predictor of
the future spot rate, which is typically how UIP is formulated for testing purposes.

The Risk and Return of the DAX, Nikkei, Bunds and JGBs for a U.S.
Dollar-Based Investor (1991-2001)
-5%
0%
5%
10%
15%
20%
0% 5% 10% 15% 20% 25% 30%
Risk
Return
HB
UHB
HJGB UHJGB
HDAX
UHDAX
HNIK
UHNIK
The main conclusion of this analysis is that the time period is absolutely crucial when
making any statements about the merits of undertaking currency risk. While it may be
true that the typical pension fund considers their long-term liability profile when
making investment decisions, and these can stretch out to 50 years or more, there is
increasing focus on marking all investment decisions to market and increased
attention on the investment returns achieved each year. The shorter the time period
over which asset allocations decisions are made, the less comforting the results
about the long-term irrelevance of currency risk.
Cumulative Unhedged Money-Market Returns in USD Terms
80
100
120
140
160
180
200
220
240
Nov-89 Apr-91 Sep-92 Feb-94 Jul-95 Dec-96 May-98 Oct-99 Mar-01
USD
dDEM
JPY
While it may be normal for plan sponsors to consider five years as the appropriate
time horizon for asset allocation decisions, it is not obvious that over such a short
time period they should expect FX to have no impact on the returns that they receive.
The chart above displays the extent of the deviation from UIP since 1989 from rolling
investments in EUR(DEM) and JPY expressed in USD. While the average deviation
might be statistically insignificant from zero, the range of deviations has been so large
that few investors are likely to feel comfortable ignoring currency risk.
So What Is the Status of Currency?
It is always hard to ascribe a consensus position to any universe of investment
managers, as is clear from subsequent chapters in this guide where key investment
managers outline their own perspectives on currency. Nevertheless, we believe that
most would agree with the view that although passive currency exposure provides no

long-term returns, currency cannot be ignored because of the wide swings in
exchange rates that persist for a long time. In other words the sheer volatility of
exchange rates forces investors to pay attention to them. Currency does not have to
be called an asset class to be given as much attention as equities and bonds.7
Risk-Based Approaches to Asset Allocation
Much of the early practical work on asset allocation, as is implied in the previous
pages, was based on the prospective returns that might be generated from different
assets.8
Yet the nature of currency suggests a risk-based framework might be more
appropriate. This would involve reducing a portfolio to the separate risks that were
embedded within in it and determining the degree to which those risks were desired.
As most investors now agree that FX exposure is a risk, it does seem a natural
starting point for considering the role of FX risk in a portfolio.
From this perspective, the zero return of FX need not have any implications for the
degree of currency exposure taken by an investor. The basis of portfolio theory is that
assets that help diversify risk are attractive even if they do not, themselves, provide
high returns. Portfolio theory suggests that an asset class might be attractive because
the diversification benefits were so great that it should be held even though it had a
negative long-run return, simply because when all other asset returns were negative
it was positive (and outperformed cash).
There is evidence that investment processes are beginning to operate from this risk-
based perspective. Instead of deciding exposure to specific asset classes (bonds), an
investment committee might decide to allocate specific risk to types of interest-rate
risk (duration, curve-spread, volatility, relative-value trades, etc.). In equity portfolios,
attention is paid to the returns from stock picking, sector selection and market level
rather than simply the return from an equity portfolio.
If the asset allocation issue is to be approached from the perspective of risk, it is
worth understanding the extent of the risk that needs to be addressed when hedging
equities, bonds and FX. The chart below depicts the return from German equities in
local currency and USD terms. The share of risk due to FX is substantial. It would be
much larger if the same chart were shown for Bunds.
DAX Annual Returns—August 1991–August 2001
-70%
-50%
-30%
-10%
10%
30%
50%
70%
90%
Aug-
91
May-
92
Feb-
93
Nov-
93
Aug-
94
May-
95
Feb-
96
Nov-
96
Aug-
97
May-
98
Feb-
99
Nov-
99
Aug-
00
May-
01
DAX return (DM)
Currency
Total return (US$)
7
A good summary of the current views of many of the leading currency managers is found in the
proceedings of the roundtable entitled How to Extract Alpha from Currency Markets in Global
Investor, February 1999.
8
Although the theoretical work, from Markowitz’s initial work onwards, has focused on risk-adjusted
measures of return, it is fair to say that this was not a widespread focus amongst investors until much
more recently.

In previous work, we have established that FX risk accounted for about two-thirds of
the risk taken in global bond portfolios. Lee Overlay Partners estimate that in the past,
30% of international equity portfolios’ local currency returns could be accounted for
by FX returns.9
All this points to FX risk being a substantial component of overall
portfolio risk.
What Is the Appropriate FX Hedge Ratio
In the 80s and early 90s, there was some debate about whether portfolios of foreign
assets should be fully hedged or fully unhedged. The full hedgers argued that
currency exposure only increased risk and hence should be removed. The advocates
of no hedging argued that hedging was expensive and, because FX returns washed
out in the long run, unnecessary.
But as it became clear over time that these corner solutions did not reflect the
complexity of the evidence regarding currency overlay, attention switched to models
that helped estimate the correct hedge ratio for foreign assets. Early analysis of the
issues surrounding the optimal currency hedge ratio was based on the universal-
hedging concept. This idea, based on the CAPM framework, was that there was one
optimal hedge ratio and the geographical location of the investor was irrelevant to this
decision.
The Theory of Optimal Hedge Ratios
The principle behind hedging is that it reduces ex ante risk for both parties involved in
the hedge (even if ex post one side wins and the other side loses). Using some fairly
tight assumptions,10
typical for simple general equilibrium microeconomic models, it
was possible to show that the minimum risk portfolio for a given level of expected
wealth involved a currency hedge.11
The extent to which hedging was required
depended only on the expected return of the world market portfolio, the expected
variance of the world market portfolio and the expected variance of the world
exchange rate.
This theoretical analysis confirmed that international portfolios were superior to
domestic portfolios. But it also explained why there should be some open FX
exposure in an optimal portfolio on account of domestic consumption of foreign
goods. Translated into real-world terms, this universal hedge ratio means that an
equity investor with knowledge of the expected risk and return of the world portfolio
and the average level of exchange-rate volatility could deduce an optimal percentage
level of currency hedging. This theoretical analysis suggested that this optimum
percentage held for all investors and all currencies—hence the title universal
hedging. The original work found that empirical values for the universal hedge could
range between 30% and 75%.12
Later work has focused on empirical estimation of
universal hedges.13
Two main criticisms have been leveled at this approach. The first is that the model is
unrealistically simplistic in its assumptions. The second is that it does not accurately
reflect risks because it ignores investors’ liabilities.
The first objection is reasonable given the relatively simplistic economic model that
has been employed, but the model is no simpler, in its way, than the assumptions
9
Lee and Buckle, The Strategic Exposure Decision, Investment and Pensions Europe, September 2000.
10
The model assumes no transaction costs, known technology, no difference between nominal and
real exchange rates, no inflation uncertainty and hence no risk premium. So, there are strong
assumptions required for the derived hedge ratios to be both optimal and universal.
11
The derivation of the general equilibrium model is found in F. Black, Equilibrium Exchange Rate
Hedging”, NBER Working Paper Series, No. 2947. The universal hedging formula is:
% hedged = (excess return of world portfolio less world portfolio variance)/ (excess return of world
portfolio less 0.5*average exchange rate variance).
12
F. Black, Universal Hedging: Optimising Currency Risk and Reward in International Equity
Portfolios, Financial Analysts Journal, July/August 1989.
13
M. Adler and P. Jorion, Universal Currency Hedges for Global Portfolios, The Journal of Portfolio
Management, Summer 1992, pp 28-35.

used in some areas of the PPP and UIP debate. So this may not be as powerful a
criticism as it first appears.
The second objection is that the assumption that each agent maximises return
subject to a risk constraint (or minimises risk subject to a return constraint) does not
accurately reflect the microeconomic choice facing each investor. There are many
investors who invest in order to minimise risk relative to a stream of liabilities, who do
not define risk as the standard deviation of absolute investment returns. As liability
streams are different, so too will the optimal hedge ratio differ. Furthermore, for
many investors, gains and losses are not equally important, as is presumed in the
mean/variance framework. For many investors, minimising downside risk for a given
level of expected return is a more appropriate objective than minimising absolute risk.
Even in a standard mean/variance framework, the presence of domestic liabilities can
restrict foreign diversification. It has been suggested that one explanation for the low
exposure of U.S. investors to international assets may be the focus on hedging
liabilities.14
What Do Actual Portfolio Data Say About Optimal Hedge Ratios?
The industry has thought hard about the issue of the optimal hedge ratio. There seem
to be two approaches to determining how much hedging should take place;
mean/variance analysis and rule-of-thumb. Neither approach pays too much attention
to the academic work described above.
A mean/variance analysis can help determine how much FX risk should be introduced
into the portfolio and can be undertaken either in absolute terms or versus liabilities.
As mean/variance analysis is the standard, universal approach to dealing with almost
any issue involving portfolio theory, it is not surprising that most practitioners adopt
this approach. The appropriate hedge ratio is established by introducing currency
forward contracts into the mean/variance optimization. The percentage hedge, which
maximizes return for the desired level of risk, is deemed to be the optimal hedge
ratio.15
The size of the currency hedge chosen will depend on the risk aversion of the
investor, the volatility of the asset’s returns, the volatility of the currency returns, the
expected asset returns, the expected currency returns, and the correlation between
the asset and currency returns. The trade-offs between these variables apply equally
for currencies as they do for any other asset.
Although it sounds scientific, this approach has drawbacks. Estimates of the
volatilities, returns and correlations for currencies all have to be calculated. It has
been shown that if there are significant errors in these estimates (particularly in the
estimates of the FX returns), then the resulting hedge ratios might be completely
wrong.16
This input dependence has always been a big drawback of the
mean/variance approach. Many solutions have been put forward to remedy this data
problem, typically involving constraining the initial portfolio and using mean/variance
to calculate small deviations away from the initial portfolio.
Such concerns, as well as practical considerations, have pushed many investors
towards the rule-of-thumb approach to the optimal currency-hedge ratio. Many
investors have been unenthusiastic about implementing strategies that required
either 100% or zero hedging. 100% hedging can involve very large cash payments to
cover losses on forward contracts. It has been the experience of many investors that
fully hedged positions raise concern amongst senior management. At the same time
zero hedging has left the likely total returns from the international assets highly
volatile. Most of the historically observed levels of the variables constituting the
universal hedging formulae come up with values in the 40%-70% range. This has led
14
M. Griffin, Why do pension and insurance portfolios hold so few international assets?, Journal of
Portfolio Management, Summer 1997.
15
M. Kritzman, The Optimal Currency Hedging Policy with Biased Forward Rates, Journal of Portfolio
Management, Summer 1993.
16
G.W. Gardner and D. Stone, Estimating Currency Hedge Ratios for International Portfolios,
Financial Analysts Journal, November/December 1995.

some to conclude that a practical solution is 50% hedged. Indeed, it has been
suggested that the correct hedge ratio is 50%, because this is the level that
minimizes investor regret at not a great cost in terms of mean/variance
performance.17
The reality is that simple, mechanical rules probably do not exist for the calculation of
optimal hedge ratios. Mean/variance might well provide a starting point for any
calculations, but it probably should not be relied on alone. To be fully aware of the
costs and benefits that unhedged exposure offers, detailed simulations of return
profiles are probably necessary. Investors must understand the extent to which
currency exposure increases their shortfall risk, as this ex post always seems to be
the key consideration.
The Predictability of Exchange Rates
There has been a wealth of academic research into the predictability of exchange
rates. Indeed, just in terms of journal inches there has been much greater effort put
into researching the macro drivers of FX returns than most other financial assets. This
probably reflects a desire by academics to test some well-used propositions about
FX, which are almost always employed in any theoretical macroeconomic analysis.
The first is PPP and the second is UIP. Both of these theories provide simple rules
that will largely determine equilibrium exchange rates and, taken together, give a
relatively straightforward model for understanding the determination of exchange
rates. It follows that if these rules generally work, then there is much less need to
worry about FX as a source of risk and return, because attention can be given to the
underlying variables which cause exchange-rate fluctuations. Indeed, some of the
strong statements made against taking FX risk have been made because these two
principles are deemed to hold.
As so much has been written on these two subjects, the best that can be achieved in
this report is an overview of the empirical status of these theories, with sufficient
references so the interested reader can access the material directly. It is worth
emphasizing that the academic community, from a theoretical perspective, operates
on the basis that both these rules apply to all FX rates—at least in the long run if not
in the short run.
Purchasing Power Parity
PPP simply states that the domestic prices of domestic and foreign traded goods are
always the same. From a theoretical perspective, if PPP holds and prices are fully
flexible, then it can be shown that real exchange rates are constant in a basic
economic model.18
While there might be a number of reasons why this might not be
true in the real world—prices are not fully flexible, technology is changing,
productivity levels are varying—academics have sought for 25 years or more to
determine the extent to which PPP was observed in the real world.
Until the mid-90s, there was general agreement that PPP did not hold and equilibrium
real exchange rates either varied a lot or were unpredictable.19
Indeed, it seems
17
F. del Vechio (1998), Currency Overlay: Strategies and Implementation Issues, AIMR Conference
proceedings from Currency Risk in Investment Portfolios. This article outlines the thought processes
behind a plan sponsor’s selection of a hedge ratio. G.W. Gardner and T. Wuillaud, Currency Risk in
International Portfolios: How Satisfying Is Optimal Hedging?, Journal of Portfolio Management,
Spring 1995, calculate the statistical properties of regret in total return terms and arrive at a 50%
hedge.
18
If P equals domestic prices and P* equals foreign prices and e is the exchange rate, then PPP
requires P=eP*. As the real exchange rate is defined to be eP*/P, then it follows that the real
exchange rate is a constant (unity).
19
Bleany and Mizen (1995), Empirical Tests of Mean Reversion in Real Exchange Rates: A Survey
Bulletin of Economic Research, 47, pp 171-195, surveys the unit root and cointegration tests
undertaken up to 1995 to test PPP. Furthermore, the standard benchmark for any real exchange-rate
model is whether it outperforms a random walk, which Meese and Rogoff (1973), Empricial
Exchange Rate Models of the 70s, Journal of International Economics, show to be the optimal
predictor of real exchange rates in the short term.

generally accepted that in the short term, real exchange rates are considered to
follow a random walk and are not constant at all.
While there has been a lot of econometric work undertaken that suggests that PPP
does not hold in the short term, there is a more recent body of econometric work that
finds that it may be more important over the longer term, such as 3-5 years. Indeed,
many studies find evidence that PPP has a half-life between three and five years. That
is, the real exchange rate slowly moves back to equilibrium over time, although it has
been shown that these estimates might well be biased upwards by a substantial
margin (4-5 fold) because of the nature of the underlying data set. Nevertheless, there
is a strand of thought that fundamental modeling has more value over the long term
than the short term.20
The economic logic for the failure of PPP seems most likely to be due to sticky prices.
If domestic prices move much more slowly than nominal exchange rates in response
to economic shocks, then PPP will not hold.21
Domestic prices may not be fully
flexible in the short term in the face of nominal and real shocks that appear from time
to time, ensuring a deviation away from PPP. These might be caused by such factors
as productivity differentials, fiscal policy, imperfectly substitutable traded goods and
changes in raw material prices. This sort of approach again fits with intuition and has
been shown to produce more acceptable statistical results than models focusing
solely on PPP.22
As happens with most of the empirical work on exchange rates, however, it is
possible to adopt a nihilistic view that data limitations make it almost impossible to
come to any firm answer on these issues using current time-series technology. It has
been shown that estimates made using quarterly or annual data, which may have
been averaged on a rolling basis, are likely to provide biased results. It has also been
suggested that very long data samples (100 years) do not provide greater statistical
power than smaller samples because of the nature of the data.23
Further doubts have
been expressed about some of the work that shows that PPP holds over the long-
term because some of the techniques used in earlier work have been found to be
flawed.24
Overall, PPP is assumed to hold in most simple models, while few academics believe
it is true in the real world. It is generally accepted that over time—and it may take
years—traded goods' price differentials will be arbitraged away.
Uncovered Interest Parity
From an academic perspective, UIP is defined as the forward exchange rate being an
unbiased estimator of future spot rates. The theorem is usually tested by analyzing
the statistical relationship between changes in spot rates over time and the changes
forecast by forward exchange rates using increasingly sophisticated time-series
techniques. If it held, then it would provide strong evidence that the long-term return
from FX is zero.
There is a wealth of evidence about the extent to which uncovered interest-rate parity
holds. While it seems now a standard assumption that this condition holds in the
20
I. Choi (1999), Testing the Random Walk Hypothesis for Real Exchange Rates, Journal of Applied
Econometrics, 14, pp 293-308, and N. Mark. and D.Y. Choi. (1997): Real Exchange Rate Prediction
Over Long Horizons, Journal of International Economics, 43, pp 29-60, both find that the random walk
model works best over short periods rather than over longer periods.
21
J.H. Rogers and M. Jenkins Haircuts or Hysteresis? Sources Of Movements In Real Exchange
Rates, Journal of International Economics, 38, pp339-360. They conclude that the costs of changing
prices regularly are such that hysteresis is the main source of PPP deviations.
22
R. Macdonald (1998) What Determines Real Exchange Rates? The Long and the Short of It,
Journal of International Financial Markets, Institutions and Money, 8, pp 117-153.
23
A.M. Taylor (2001), Potential Pitfalls for the Purchasing Power Parity Puzzle? Sampling and
Specification Biases in Mean-Reversion Tests of the Law Of One Price Econometrica, 69, pp 473-
498.
24
J. Berkowitz and L. Georgianni (1997), Long-Horizon Exchange Rate Predictability?”, IMF Working
Paper No. 97/6, show that work by Mark (1995) and Mark and Choi (1997) produces results that can
also be generated by two time-series variables with no relationship to each other.

financial markets community, there is much less support for this notion holding in the
academic community. Ironically, most of the academic analysis assumes efficient
markets, so it is problematic when the econometrics provide evidence that does not
support this view.25
Indeed, the starting point for most current academic analysis is to understand why
UIP does not hold, rather than demonstrating that it does, because few statistical
studies have found support for UIP. This work starts by trying to calculate the
statistical characteristics of the relationship between the forward premium and actual
future spot rates. Economic models have emerged that show that the persistence of
a forward premium in excess of the spot movements and a negative correlation
between this amount and the level of the spot rate are not evidence of market
irrationality.26
This is because the risk premium may well be correlated with the spot
rate or because of the presence of noise traders.27
It has also been suggested that the
reason UIP fails is because of governments’ systematic management of interest
differentials, so the UIP equation is actually part of a system of simultaneous
equations that need to be estimated.28
But the more favoured explanation of the
breakdown is due to the existence of a (time-varying and perhaps also asymmetric)
risk premium.
Since there are few economists who are prepared to accept the notion of market
inefficiency, there is a continual effort to show that UIP holds. Even though the
weight of econometric evidence is that UIP does not hold in the simple form, few
theoretical models are prepared to assume the failure of UIP. While academics do not
like the implications of their own modeling, financial market participants are happy to
claim that these error terms can be traded in a systematically profitable manner. For
years financial market participants have been using tools to seek out repeatable
patterns in market prices that academics do not believe exist in efficient markets.29
It is important to emphasize that the active management of currencies does not
require the rejection of UIP. One recent study of UIP across both developed and
emerging countries found no statistical evidence that UIP could be rejected, because
it found the average deviation between future spot rates and forward rates to be
2.9% and the average standard deviation to be 4.9%.30
This is a similar result to that
shown above in our calculations. In our view, however, this is clear evidence that FX
risk needs to be managed simply because of the potential impact it might otherwise
have on portfolio returns. If this return distribution is normal, and centred around zero,
there is as much chance (50%) of a return either below -3.25% or above 3.25%
versus inside that level. This is not a great distribution for a passive investor. While
the debate will rage about how long it takes for such a move to unwind back to
normal (the half-life of any currency deviation), it will typically take only one such
move before an investor has some serious questions to answer before an
investment-policy committee.
Modeling Exchange Rates
There is academic controversy about both UIP and PPP. In the real world, it does
matter whether we assume that PPP and UIP hold. If they do, we can be more
comfortable about downgrading the importance of FX risk. If they do not, then FX
exposures become much more problematic.
25
Many papers have cast doubt on the standard formulation of UIP. See, for example, E. Fama (1984)
Forward and Spot Exchange Rates, Journal of Monetary Economics, 14.
26
W. Hai, N. Mark, Y. Wu (1997), Understanding Spot and Forward Exchange Rate Regressions,
Journal of Applied Econometrics, 12, pp 715-734.
27
N. Mark and Y. Wu (1998), Rethinking Deviations from Uncovered Interest Parity: The Role of
Covariance Risk and Noise, Economic Journal, 451, pp 1686-1706.
28
B.T. McCallum (1994), A Reconsideration of the UIP Relationship, Journal of Monetary Economics,
33, pp 105-32.
29
P. Sujaras and R Sweeney (1992), in Profit-Making Speculation in Foreign Exchange Markets,
show how spot FX rule-based trading can produce systematic profits—even after adjusting for risk.
The technical analysis, which dominates in the FX markets, is based upon repeatable patterns.
30
E. Tanner (1998), Deviations from UIP. A Global Guide to Where the Action Is, IMF Working Paper
98/117.

If interest-rate differentials do not always offset currency moves, then it matters
whether real exchange rates are stable or not. If they are stable, then it will not
matter much if UIP does not hold since the extent to which it has not held is second
order simply because of the low volatility of short-rate returns relative to FX returns.
However, if real exchange rates are variable, then it might matter very much. It might
be, for example, that not only did interest rates not compensate for a currency move,
but also that the currency moved permanently to a new equilibrium level, leaving a
permanent impact on the returns of the portfolio. A permanent 15% appreciation of
an exchange rate is a problem for investors if the interest differential remains at 5%.
Most modeling of exchange rates has sought to establish the factors driving real
exchange rates. If both PPP and UIP hold, then there is a direct and straightforward
relationship between real exchange rates and real interest rates.31
But just as there
has been doubt about some other standard theories outlined earlier, so there has
been much doubt about the empirical relationship between real exchange rates and
real interest rates.32
The current state of academic research is that there appears to
be a weak, long-term relationship between real exchange rates and real interest rates.
One paper concluded that on balance it finds more encouraging results than in earlier
studies, but it still remains to be demonstrated that the real-exchange-rate/real-
interest-rate relationship is the linchpin to explaining exchange-rate movements.33
While there is much disagreement about the correct interpretation of historical
exchange-rate data, there is much less academic disagreement that long-term
differentials in productivity, real interest rates and per capita income display predictive
power [even though] monetary models are more powerful.34
Because there is strong
evidence that fundamental changes in these factors occur over time between
countries, we have strong a priori reasons to believe that structural changes in real
exchange rates are likely to occur over time.35
Indeed, it has been argued that the reason why there has not been much of a
relationship between real exchange rates and real interest differentials found by
empirical work is because the relationship was more likely to hold over long periods
rather than when analysing high frequency data.36
When the analysis was undertaken
using panel data and co-integration techniques, there were signs that the real interest
differential was reasonably important even though analysis for single countries has
tended to show that the relationship is quite weak.37
While most participants in the FX
markets believe these links exist, there is doubt about the econometric techniques
that are used to analyze these time series.
31
If the nominal exchange rate is determined by interest differentials and PPP holds, then the real
exchange rate is a function only of real interest-rate differentials.
32
H.J. Edison and D. Pauls (1992), A Reassessment of the Relationship Between Real Exchange
Rates and Real Interest Rate: 1974-1990, Journal of Monetary Economics, 31, pp 165-87, is one
example of studies that found no substantial relationship between real exchange rates and interest
rates.
33
H.J. Edison and W.R. Melick, Alternative Approaches to Real Exchange Rates and Real Interest
Rates: Three Up and Two Down, International Journal of Finance and Economics, April 1999.
34
N. Mark and D. Y. Choi (1997), Real Exchange Rate Predictions over Long Horizons, Journal of
International Economics. N.Mark and D. Sul (2001), Nominal Exchange Rates and Monetary
Fundamentals, Journal of International Economics (53), pp 29-52, provides an analysis of panel data
and argue that there is evidence against the random walk hypothesis, and that fundamental factors
are important. N. Mark (1995), Exchange Rates and Fundamentals: Evidence on Long-Horizon
Predictability, American Economic Review, 1995, pp 201-218.
35
M.B. Canzoneri, R.E. Cumby and B. Diba (1999), Relative Labour Productivity and the Real
Exchange Rate in the Long Run: Evidence for a Panel of OECD Countries, Journal of International
Economics (47), pp 245-266, finds evidence that real exchange-rate changes are linked to relative
labour productivity.
36
M. Baxter (1994), Real Exchange Rates and Real Interest Differentials. Have We Missed the
Business Cycle Relationship ?, Journal of Monetary Economics, pp 6-37.
37
R. Macdonald and J. Nagayasu (2000), The Long-Run Relationship Between Real Exchange Rates
and Real Interest Rate Differentials: A Panel Study, IMF Staff Papers, vol 47, issue 1. A. Alexius and
J. Nilsson (2000), Real Exchange Rates and Fundamentals: Evidence from 15 OECD Countries, Open
Economies Review, 11, pp 383-397. J. Strauss (1999), Productivity Differentials, The Relative Price of
Non-Tradables and Real Exchange Rates, Journal of International Money and Finance, vol 18, issue 3.

Some modeling has suggested that real exchange rates have permanent changes and
transitory changes and that exchange rates adjust over time around these permanent
changes. A priori, this seems a reasonable interpretation of many of the changes that
have taken place in exchange rates over the last two decades; providing a rigorous
statistical proof would not only be tricky, it might also contravene much of the rational
expectations critique of economic modeling. After all, if we can find models that
explain real exchange rates this easily, then we have to suppose that it is not possible
to make much money from exchange-rate trading. But this is apparently contradicted
by the studies of the alpha generated in FX by portfolio managers and also by the
profits that financial intermediaries seem to be able to generate regularly in this area.
Summary
In the short run (i.e., less than a year), noise seems to dominate, while in the longer
run (3-5 years), the fundamentals reassert themselves. But there is no sense in the
literature that FX exposure is a wash empirically—the fluctuations are very real and
very large—even though the universal assumption is that FX is a wash, it is just that
for several practical reasons, it has proved hard discovering what the right form of
analysis is.
It has been argued that currencies did not make a great contribution to returns over
the last 30 years, and that the correlation between equity and FX returns has been
negative. In this case, not only does FX risk not need to be hedged, it is also naturally
hedged within a portfolio. The above sheds enough doubt on this sort of assertion
that investors who are currently ignoring FX risk, on these grounds alone, are unlikely
to be content over the long-term.
There is also strong evidence to suggest that equilibrium exchange rates are not
constant, but vary over time. But if equilibrium real exchange rates cannot be certainly
constant over time and we cannot assume that exchange rate fluctuations are offset
by interest differentials, then we are not really in a position to state forcefully that
either that the long-term return from FX is zero or that it is pointless to consider
actively managing FX risk.
In other words, it seems incorrect to argue that equilibrium exchange rates vary
around a fairly constant level. If they do not, then some currencies will gain
systematically, and some will lose, and it is not possible to argue that long-term
investors will be indifferent to currency risk.
By considering the theoretical basis for the actual definition of an asset class, we
have attempted to demonstrate that the lack of attention paid to currency because it
is thought not to be an asset class or because FX returns wash out over time are not
strong reasons for ignoring currency risk. Indeed, any investors with an investment
mark-to-market of under five years ought to have a very strong view of how currency
is to be dealt with.
Perhaps the main conclusion from this brief review of the academic empirical work on
modeling exchange rates is that there are many fewer controversial propositions
about exchange rates than there are controversies over the statistical techniques
used to test them. There are many market participants who will disagree with the
summary of the current literature presented in this article. That there is such
controversy is good news for those trying to make money in the markets.

A Consultant’s View of Currency Risk and Overlay
Bill Muysken
Head Manager Research—Global
William M. Mercer Investment Consulting
(44) 20 7977-8603
Every year, somewhere in the world, some pension plan trustees will find out that
foreign-currency exposure has had an adverse impact on their investment returns.
Not surprisingly, Mercer receives a regular stream of requests from clients for advice
on how to deal with the foreign-currency exposures associated with international
investments. In this brief note, we provide an overview of our current thinking on
some of the key issues surrounding the treatment of currency risk and of currency
overlay.
Currency overlay management involves managing the currency exposures in an
investment portfolio separately from the underlying asset exposures. It is a relatively
young business. As far as we are aware, the first ever specialist currency overlay
mandate was awarded in the UK in April 1985.
While we estimate that 200 to 300 large pension plans worldwide currently use
currency overlay managers (as at mid-2000), most do not. In a recent survey
conducted by William M. Mercer of 111 plan sponsors accounting for over US$400
billion of assets, the unweighted average allocation to international assets across all
respondents was 27%. Yet only 12 of the 111 respondents use specialist currency
overlay managers. Two more indicated that they were intending to hire specialist
currency overlay managers in the near future, and two others indicated that they
manage their currency exposures internally. Of the managers that have currency
overlay programmes, 75% were satisfied with the results of the currency-hedging
programme to date.
Only 49% of all respondents gave explicit consideration to currency exposure when
the benchmark asset mix for their plan was last reviewed. The proportions by country
ranged from 23% for UK respondents to 70% for Canadian respondents. More than
half the respondents use unhedged benchmarks for international equities, although a
significant minority use partially hedged benchmarks. Among those plans with
partially hedged benchmarks, the hedge ratios ranged from 5% to 75%, with 50%
being the most common choice.
How Do We Measure Foreign-Currency Exposure in Investment
Portfolios?
The foreign-currency exposure of an investment portfolio is generally measured as
the proportion of the portfolio that is denominated in foreign currencies, less the
proportion of this exposure that is hedged back to the base currency. For example, if
a U.S.-based investment portfolio valued at US$100 million includes US$20 million
worth of assets denominated in foreign currencies, of which 50% is hedged back to
the US$, then the foreign-currency exposure of this portfolio is 10%.
For equity investments, this measure of foreign-currency exposure does not tell the
full story. A company doing business in foreign markets may be taking on currency
exposures at the corporate level that differ from the currency in which its shares are
denominated. These can be described as implicit foreign-currency exposures. While
implicit currency exposures can differ greatly from nominal currency exposures at the
individual company level, these differences tend to average out at the overall portfolio
level, and will therefore be ignored for the remainder of this note.
How Should Pension Plans Decide Whether to Hedge Part or All of Their
Foreign-Currency Exposure Back to Their Base Currency?
In order to answer this question, two separate issues need to be considered:

• The first issue is what the plan’s long-term strategic benchmark exposure to
foreign currency should be. Should it be equal to the benchmark exposure to
foreign assets (which would imply unhedged benchmarks for foreign equities and
bonds), or zero (which would imply fully hedged benchmarks), or somewhere in
between?
• The second issue is whether or not the currency exposures should be actively
managed relative to their benchmark levels, and if so, by whom. This is an
implementation issue, and depends on the ability of various parties to add value
through active currency management. It is, in part, another permutation of the
active versus passive management issue, and, in part, another permutation of the
balanced versus specialist management issue.
The approach that we advocate is for pension plans to consider the longer-term strategic
issues first, before moving on to consider the implementation issues. This framework for
analysing currency management issues helps to make them easier to analyse and discuss
without creating confusion. It is analogous to the approach normally used by pension
plans to analyse other types of investment management issues.
Long-Term Strategy—What Should the Benchmark Exposure to Foreign
Currency Be?
This is a strategic issue, and is similar to the decision on the plan’s long-term strategic
benchmark asset mix in this respect. Ideally, the currency-benchmark issue should be
reviewed on a regular basis as part of the overall review of a pension plan’s long-term
investment strategy. Decisions on this issue should take into account the longer-term
risk and return implications of the main alternatives.
Because we want to consider this issue from a longer-term strategic perspective, we
can start by assuming that all asset classes and currencies are fairly valued at the
moment and that all asset classes and currencies are passively managed. (The
appropriate response to any temporary misvaluations can be considered separately
after the decision on the long-term strategic benchmark has been settled). If we
assume that all asset classes and currencies are fairly valued, it seems reasonable to
assume that the longer-term return impact of currency hedging will be close to zero.
This assumption allows us to put the longer-term return implications to one side to
simplify the analysis. The analysis can then focus solely on the longer-term risk
implications of the main alternatives.
The key point about currency hedging is that it reduces risk, and this is illustrated in
the following chart. In this chart, the vertical scale measures the historical volatility of
annual returns, over the period from 1 January 1974 to 30 June 2000.
Impact of Global Diversification Within Equities on Risk Level (with
Hedging)
13%
14%
15%
16%
17%
18%
19%
20%
21%
0% 20% 40% 60% 80% 100%
Percentage of equity portfolio invested outside the United States
Risklevel(volatilityofannualreturns)
Unhedged
25% Hedged
50% Hedged
75% Hedged
100% Hedged
(based on data from January 1974 to June 2000)
Source: William M Mercer

The horizontal scale indicates the percentage of a U.S. pension plan’s equity portfolio
invested internationally. Zero on this scale indicates a 100% allocation to domestic
U.S. equities, and 100% indicated a 100% allocation to international equities. The
lines on the chart show the historical risk levels for all of the possible mixes in
between these two extremes (assuming that the mix between the two asset classes
was rebalanced each month throughout the period). The top lines show an unhedged
exposure and the additional lines show how the risk levels would have varied if the
non-U.S. equities had been 25% hedged, 50% hedged, 75% hedged or 100%
hedged back to the US$.
As non-U.S. equities are introduced into the portfolio mix (whether hedged or
unhedged), there are some diversification benefits, so the risk curve starts to slope
downwards from the left hand side. Beyond a certain point, however (in this case
about 25%), increasing the exposure to unhedged non-U.S. equities actually
increases risk because the extra diversification benefits are being outweighed by the
impact of the extra currency risk. Beyond this point it starts to make sense to hedge
some of the currency exposure, so that the diversification benefits of increasing
international exposure are not offset by the extra currency risk.
If we consider a balanced portfolio, the chart below shows how the risk levels would
have varied according to the exposure to foreign currency included in the benchmark
asset mix for that portfolio. The balanced portfolio in this example has a benchmark
asset mix of 40% in U.S. equities, 20% in non-U.S. equities, 30% in U.S. fixed
income and 10% in non-U.S. fixed income. This gives a total allocation to foreign
assets of 30%, so a foreign-currency exposure of 30% corresponds to an unhedged
benchmark. Foreign-currency exposures below 30% correspond to partial hedging.
Foreign-currency exposures above 30% correspond to an unhedged benchmark plus
additional naked currency exposure.
Effectiveness of Currency Hedging for a Balanced Portfolio
9%
10%
11%
0% 5% 10% 15% 20% 25% 30% 35% 40%
Benchmark exposure to foreign currency
Risklevelplusallowancefortransaction
costs
(based on data from January 1974 to June 2000)
Source: William M Mercer
In this particular example a benchmark currency exposure in the region of 10% would
have been close to optimal. This could have been achieved by adopting a fully hedged
benchmark for the 10% allocation to international bonds, and a 50% hedged
benchmark for the 20% allocation to international equities.
These results would have looked different if the analysis had been carried out from a
different base-currency perspective, or for a different benchmark asset mix. Also, the
results would have varied according to the time period that the analysis was based
on. Repeating the analysis over a range of different time periods is a good way of
getting a sense of the estimation error inherent in this type of analysis.
The risk level analysis presented above is an example of the type of analysis that
Mercer believes pension plans should consider when they next review their
benchmark exposure to foreign currency. In practice, when it comes to taking a final
decision on this issue, some pension plans also give consideration to other factors

such as peer-group risk, the potential performance of active managers, cash-flow
considerations, regret risk, and long-term currency views.
Implementation—Active, Passive or Do Nothing?
The most basic issue is whether currency exposures should be managed passively, or
actively, or on a do nothing basis (i.e., leave them to be driven by the equity and
bond-market exposures in the underlying portfolio).
The do nothing approach is easy to dismiss. Firstly, it implies an unhedged
benchmark, which, as discussed above, will often be sub-optimal from a strategic
standpoint. Secondly, Mercer’s analysis has confirmed a little-known and somewhat
surprising fact: the countries with the best performing equity markets tend to have
the weakest currencies, and vice versa. Hence, international equity managers who
adopt the do nothing approach as a matter of policy are either pursuing sub-optimal
approaches to country allocation or sub-optimal approaches to currency management,
or a bit of both.
The active versus passive currency management debate is a subset of the broader
debate on active versus passive investment management more generally. There is
scope for a range of views on this issue, both as it relates to investment
management in general, and as it relates to currency management in particular. On
balance, we believe that active currency management is worthy of serious
consideration, subject to two important provisos:
• Firstly, active currency management should only be permitted in cases where the
investment manager in question is considered to be capable of adding value in
this area. Otherwise it would be preferable to restrict that manager’s currency
hedging activity to passive hedging only, or to consider hiring a specialist
currency overlay manager.
• Secondly, the investment guidelines should specify clear limits on the scope for
currency hedging. As with any other area of active investment management,
even the best active currency managers in the world will underperform over
some short periods. The investment guidelines should be set so that the extent
of any such underperformance is considered to be unlikely to exceed the limits
that the plan sponsor is prepared to tolerate, except in the most extreme
circumstances.
The empirical data on past performance of specialist currency overlay managers
clearly favour the case for active currency management. As has been shown
elsewhere, all the reported analysis suggests that active currency management
significantly improves returns and has also tended to reduce the variability of returns.
Whether or not specialist currency overlay managers are likely to continue to
outperform on average in the future is a more difficult question. Nevertheless,
inefficiencies remain in the FX markets. A high proportion of foreign-exchange trading
is undertaken by market participants whose transactions are driven by reasons other
than profit maximisation. Firstly, there are central banks and supranational
organisations whose primary objective is to stabilise bond and currency markets.
Secondly, there are international investors whose primary objective is to consummate
international investment transactions. Thirdly, there are corporations and other market
participants seeking simply to hedge unwanted currency risks. These three groups
are not particularly price-sensitive, and their presence in the market may create
inefficiencies that active currency overlay managers have been able to exploit.
It seems quite plausible that these inefficiencies will continue to exist for the
foreseeable future. Even if the usage of skilled, active currency management among
large pension plans world-wide were to increase substantially, it would still account
for only a small proportion of total foreign-exchange trading. Another part of the
explanation is that transaction costs in foreign-exchange markets are very low. This
means that active currency managers only have a relatively low transaction-cost
hurdle to overcome before they can add value through their active currency-
management decisions.

Summary and Conclusions
In our view, the most important message for plan sponsors and trustees is that it is
important to consider the long-term strategic issue of what the benchmark exposure
to currency should be separately from the implementation issues.
Ideally, the currency-benchmark issue should be reviewed on a regular basis as part
of the overall review of a pension plan’s long-term investment strategy. We believe
that this review should include an analysis of the implications of the different options
for the risk level of the plan’s overall benchmark asset mix. The results of this analysis
will depend on the base currency of the pension plan, the plan’s benchmark asset
mix, and the definition of risk used for the purposes of this analysis.
Once the benchmark has been determined, it makes sense to then move on to
consider implementation issues. We believe that active currency management is
worthy of serious consideration, but that active currency management should only be
permitted in cases where the investment manager in question is considered capable
of adding value in this area, and where the investment guidelines given to the
manager concerned specify clear limits on the scope for currency hedging. Otherwise
it would be preferable to restrict that manager’s currency-hedging activity to passive
hedging only, or to consider hiring a specialist currency overlay manager.

Establishing the Currency Risks of a Portfolio
Harriett M. Richmond
Head of Currency Management
JPMorgan Fleming Asset Management
(44) 207 742-5443
Michael Sager
Head of Currency Research
JPMorgan Fleming Asset Management
(44) 207 742-5048
JPMorgan Fleming Asset Management is one of the world’s largest global asset
managers, with a long track record of assisting clients to diversify their portfolios
internationally. From the very earliest days of global investing and the move away
from fixed exchange rates in the early 1970s, the firm adhered to the view that
currency exposures should be treated as a separate decision within a client’s overall
asset allocation. From these experiences, the firm progressed in the 1980s to the
development of the currency overlay approach, where these skills could be applied to
assets managed by other firms. Along with several other early entrants, the firm
became a pioneer in what has now become an established industry. As at June 2001,
over $60 billion in assets are managed by the specialist currency management team
at JPMorgan Fleming Asset Management, with a continuous track record for some
clients exceeding a dozen years.
The objective of the JPMorgan Fleming Asset Management currency team is to
provide currency solutions for a wide variety of clients. This could mean controlling
risk using sophisticated passive management techniques, or active management of
both major and emerging-market currencies, and even currency as an alternative
investment.
Separation of currency exposures in the overall portfolio context operates on
essentially three levels:
• Separation at the Policy or Benchmark Level. This is the key risk-control issue,
because currencies add no theoretical long-term return to portfolios but do add
volatility. So investors may select a globally diversified portfolio with limited
currency risk by hedging fully or partially back to their base currency. Lower
currency risk may allow investors to assume additional risk in other assets.
• Separation at the Tactical Level. This means that although underlying asset
allocation may favour Japanese equities, for example, the yen may not look
attractive. Simple financial instruments can be used to separate these decisions.
Furthermore, different fundamental and technical forces drive equity and currency
markets, making the logic for separating these decisions compelling.
• Separation of Decision-Makers. There is little reason to believe that investors
who excel at stock picking will also excel at currency management. Specialisation
should result in better overall decision-making, with low correlation between the
different decisions.
Strategic Separation—The Benchmark Decision
The relevance of currency management has increased in recent years due to a
significant rise in the proportion of assets held within portfolios that are denominated
in a currency other than the investor’s base currency. Cross-border equity or fixed-
income investment (and increasingly alternatives such as private equity and real
estate as well) generate an inherited currency exposure, which can make an
important contribution to overall portfolio performance. The first step to managing this
exposure is to establish a strategic currency benchmark that can range anywhere
from fully hedged to unhedged. The hedge ratio can be fixed or can vary dynamically,
depending on underlying currency moves. This degree of hedging should be linked to

A Guide to Currency Overlay Management

A Guide to Currency Overlay Management

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