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Macro Insight
A disciplined approach to currency
management
17 March 2017
For Professional Client
and Institutional Investor Use Only
Summary
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When investing globally, a key portfolio
management question is how to deal with foreign
currency exposures: should we hedge overseas
currencies? Or should we accept currency risk?
And how should we manage this risk in our
portfolio over time?

We need to be thoughtful about how we tackle
this. In our global multi-asset portfolios, we take a
structured and disciplined approach to currency
management
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
We believe there is a compelling case for hedging
currency exposures in “safety” asset classes, like
global government bonds. Otherwise currency risk
will dominate the volatility of global bonds
different industries, and different economic cycles.
Because of this, we believe it is right to allocate to
overseas asset classes.
But there is a challenge. When we invest in an
overseas asset market, we also invest in foreign
currency. This is an issue because currencies can be
volatile, even over long investment horizons (see
figure 1).
Figure 1: Sterling against the US dollar
GBPUSD
2.2
2.0
1.8
1.6
1.4
For riskier asset classes, such as global equities,
the portfolio benefit of hedging currency exposure
is ambiguous. And the costs to hedging are not
“frictionless”. Our starting point is to leave currency
risk unhedged
Source: HSBC Global Asset Management, Global Investment Strategy
But we also need to be active. When market
exchange rates move significantly, we need to
adapt how we deal with currency risk. We discuss
this idea in the context of recent moves in
sterling/dollar and how we have responded in UKbased global multi-asset portfolios
What can we do about this? Well, we either accept
currency volatility or we can (partly) hedge this risk.
Some say currencies are a zero-sum game. Others
argue that currency fluctuations can be quite random.
This means that we can’t assume that we will always
make money when investing in major currencies.
Introduction
One way to approach multi-asset investing is to focus
solely on domestic asset classes. Taking this “home
bias” does avoid currency risk, but it also restricts our
investment universe and reduces our flexibility. In turn,
this limits our ability to deliver good risk-adjusted
returns to our clients.
Taking a global approach to multi-asset investing is
beneficial. This brings increased diversification
benefits which leads to less volatility in overall returns
and enables us to take exposure to different countries,
1.2
1.0
1997
2002
2007
2012
2017
Given that currencies produce additional volatility for
our portfolios, hedging currency exposure (using FX
forwards) could make sense. But we need to
recognise that the cost of hedging is not “frictionless”.
A typical assumption is that the price of a currency
hedge should be the differential in interest rates
between the two economies concerned. But since the
possible strategies that the investor could adopt – (i)
global bonds with currency exposures hedged, (ii)
global bonds unhedged, (iii) global equities hedged,
and (iv), global equities unhedged.
financial crisis, this has tended not to be the case in
some major FX rates. What’s more, the trading costs
associated with currency hedging are not zero.
Therefore, the key question is whether the cost of
hedging is justifiable versus the saving we expect to
make in volatility terms.
On the basis of this data, since 1990, a US-based
investor would have enjoyed strong returns across all
these strategies! But the decision about whether to
remove currency risk (by hedging) is still important.
Our conclusion is that it is worth hedging overseas
bond exposures, but it is less clear-cut for overseas
equities.
The easiest way to see this is by looking at the Sharpe
ratios in the table under the chart. The Sharpe ratio
shows the overall (excess) return above the risk-free
rate which is adjusted for volatility.
This research-led conclusion informs the HSBC Global
Asset Management default policy which is to hedge
overseas bond exposures but typically leave foreign
equity asset classes unhedged.
For global government bonds, the decision to hedge
the overseas currency exposure dramatically improves
the historic risk-adjusted return. The Sharpe ratio
increases from 0.49 to 1.
A structured approach to FX hedging
We take a disciplined and structured approach to
thinking about asset allocation. This starts with our
valuation (risk premia) framework covering 250+ asset
classes. This enables us to identify where relative
opportunities might exist.
The recent past has been a strong market
environment for global bonds, so we shouldn’t expect
such high Sharpe ratios from bonds in the future. But
the large gap between the currency-hedged and
unhedged strategies is meaningful.
A key step in the process is to think about currencies
like we would do any other asset class. This is
because currency exposure creates a risk and –
perhaps – the potential for return in our portfolio.
At the same time, for global equities, there seems to
have been a benefit associated with leaving currency
exposures unhedged, but the difference in riskadjusted returns is much smaller than what we saw
with global bonds.
When a US dollar-based investor allocates to global
equities on an unhedged basis, we can think about the
overall investment return as being partly driven by the
equity exposure and partly-driven by the currency
exposure. The important relationship is how that
currency element interacts with the underlying asset
class position.
The “optimal hedge ratio”
A more refined way to make the same point is to think
about a concept known as the “optimal hedge ratio”.
What we mean by this is the percentage of foreign
exposure which should be hedged back into the
domestic currency in order to minimise portfolio risk at
a particular point in time. An “optimal hedge ratio” of 1
means that we should fully hedge. An optimal hedge
ratio of zero means that we don’t hedge at all.
Figure 2: The impact of currency exposures
800
Global Bonds (U)
Global Equity (U)
Global Bonds (H)
Global Equity (H)
600
Figure 3 shows that for “safety” asset classes, such as
UK government bonds, the “optimal hedge ratio” has
historically been stable at around 1; it is almost always
worth fully hedging.
400
200
Figure 3: UK Bonds & Equity “optimal hedge ratio”
2015
Global Equity
0.09
0.25
Source: HSBC Global Asset Management Global Investment Strategy, total
returns and Sharpe ratio from January 1990- February 2017
2000
2004 2008 2012
2010
2000 1995
2004
20082005
2012
Figure 2 helps
us to see this relationship.
The2000
chart
Index
shows the impactIndex
of currency exposure for aIndex
dollarbased investor focussing on global developed market
(DM) bonds and global (DM) equities. There are four
0.0 0.2 0.4 0.6 0.8 1.0
Global Bonds
1.00
0.49
Bonds
JapanUK
Equity
1990
UK Equity
0.0 0.2 0.4 0.6 0.8 1.0
2010
Japan
Bonds
Eurozone
Equity
0.0 0.2 0.4 0.6 0.8 1.0
Sharpe Ratio
Hedged
Unhedged
2005
0.0 0.2 0.4 0.6 0.8 1.0
1995
2000
Germany
Bonds
0.0 0.2 0.4 0.6 0.8 1.0
0.0 0.2 0.4 0.6 0.8 1.0
0
1990
1995
2000 2005
2000
20102010
IndexIndex
1990
2000
2010
Index
Source: HSBC Global Asset Management Global Investment Strategy, “optimal
hedge ratio” from the perspective of a US dollar investor
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To hedge or not to hedge?
economic and political uncertainties persist, creating
downside worries.
Taken altogether, the way to think about this is that the
volatility of government bond returns is dwarfed by the
large fluctuations in currency markets. If we want
bonds to act as a source of “safety” in our portfolio, we
have to hedge the currency risk out. This idea holds up
across different currencies and for different time
periods.1
From our perspective, however, the important point is
that sterling has cheapened materially relative to its
levels pre-Brexit referendum. This means that the
balance of risks has changed. We believe that it
makes sense to acknowledge this shift in the market
odds in our portfolios. As such, we have moved to
partially hedge developed market equity exposures for
sterling-based global multi-asset portfolios.
But in riskier asset classes, such as UK equities, we
find that the “optimal hedge ratio” has tended to be
quite variable over time. And, unlike with government
bonds, the Sharpe ratio since 1990 (i.e. figure 2) is not
improved by hedging overseas exposure.
Figure 4: Sterling against the US dollar, euro and
Japanese yen
1.6
180
GBPEUR
1.5
GBPJPY (RHS)
170
160
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Consequently, the portfolio benefits associated with
currency hedging in equities are ambiguous. Research
doesn’t provide a strong case to hedge and the cost of
the hedge is not “frictionless”. In practice, the hedging
decision may depend on which currency exposures
are being taken and on the home country or currency
of the investor.
150
1.3
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130
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120
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Dec-15 Feb-16
Being active: a recent case study
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Apr-16
Jun-16
Aug-16
Oct-16
Dec-16
Source: Thomson Reuters Datastream, as of February 2017
We take an active approach to asset allocation in our
multi-asset portfolios. By this we mean that we adjust
portfolio exposures over time to reflect the evolving
market-implied rewards. It makes sense to think about
currency similarly. In other words, if we have a view on
currencies, we might move away from our “default
policy” to reflect our investment conviction.
Core principles
Our multi-asset portfolios are invested globally across
many different regions and asset classes. This
enables us to gain a diversification benefit from
different economic cycles and industries.
But it presents a challenge: when we invest in
overseas asset classes, we also invest in foreign
currencies. We have a choice to either accept the FX
risk, or hedge it (using forwards).
The best way to see this is through a recent case
study.
How has our currency positioning adjusted in a UKbased global multi-asset portfolio in response to the
recent sharp depreciation in sterling?
The costs to hedging are not “frictionless”. Investors
face a dilemma about whether the costs of hedging
are justified against any saving in volatility.
At the start of 2016, our currency valuation framework
indicated that sterling was over-valued versus the
dollar. Based on market prices, our tactical view on
sterling versus other major currencies reinforced the
“default policy” that global equities should be
unhedged for sterling-based portfolios.
When currency risk makes up the overwhelming
proportion of asset class risk (e.g. for global
government bonds), it makes sense to hedge. Where
currency risk makes up a smaller proportion of overall
asset class risk, the case for hedging is more
ambiguous. We should typically take global equity
exposure on an unhedged basis.
But, in the immediate aftermath of the Brexit vote,
sterling depreciated dramatically versus other major
currencies.
However, we also need to account for current market
pricing. When exchange rates move decisively, active
currency management can be used to enhance
portfolio performance.
Following this, our analysis implies that the risk to
sterling/dollar has become more “two-way”. Valuation
considerations imply that there is some scope for
sterling FX appreciation, over time. Simultaneously,
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GBPUSD
The main reason for this is that the relationship
between currencies and equities is much more
complicated. For example, many companies have
revenues and costs denominated in a wide range of
currencies.
Kim Kooner – Global Investment Strategy
For example: see Campbell (2010) “Global currency hedging”; James, Marsh and Sarno (2012) “Handbook of Exchange Rates”
3
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