Within the first few weeks of 2016 the Canadian dollar has dished out pain and joy in abundance. The irony is that within a single month both bulls and bears experienced these emotions in extremes. The currency first fell dramatically in the early part of January only to fully reverse by early February.
How does one manage these risks in a portfolio context: should we 100% hedge or 0% hedge? Maybe neither, as both of these strategies expresses the strongest possible directional view on a currency pair in a world where strong convictions easily turn into severe regret – no small thanks to unconventional central bank policies.
An investor could 100% hedge and reduce currency volatility significantly, but this would also imply that the investor is willing to forfeit any potential returns from a weakening domestic currency. A case in point: if a Canadian investor decides to hedge its U.S. dollar investments in full, any weakness in the Canadian dollar would not benefit the portfolio. Unlike the 100% hedge where an investor is willing to forfeit all currency gains in favour of reduced currency volatility, the 0% strategy presents the other extreme as the investor takes on full currency risk and potential returns (or losses). By choosing a static 0% or 100% hedge, the investor locks in a binary outcome on the currency – the investor is either (very) right or (very) wrong on the currency view, no in between.
Currency developments during the last few years suggest that static hedging strategies can be costly as currencies, like any asset class, do not move in straight lines. Instead, with the increased volatility that is returning to all markets (evident in currency markets during the last 18 months), the need for actively managing currency volatility, exposures and hedge ratios have increased rather than decreased.
At Signature we believe that hedging is part of a comprehensive currency management strategy and should be integrated with portfolio construction, investment allocation and a comprehensive macro-view. Part two of the currency management blog will take a closer look at how to manage binary outcomes in a currency world.