A significant percentage of publically listed companies, in particular, and companies more generally, have earnings, expenses or both which are influenced by currencies other than their home market currency. They might buy raw materials or components from abroad, or buy them from a local supplier who imports. They might sell the products or services into foreign markets or have foreign subsidiaries operating in territories that use a different currency.
And it’s not only companies. In a world of globalisation, all kinds of assets and financial instruments are denominated in different currencies or are influenced by them. Currency management is the appraisal of how currency fluctuations impact or could impact a business or institution and the subsequent structuring and implementation of strategies to limit exposure to currency risk. The ultimate aim of money management is for currency fluctuations, large and small, to have a minimal impact on the bottom line of earnings or profit when translated into the home currency.
Why do Institutional Investors Invest Abroad?
There are two main reasons the investors invest internationally and do not solely focus on financial instruments such as shares, indices and bonds from their domestic market and denominated in their domestic currency.
The first reason to invest in financial instruments from around the world is to diversify risk. If financial markets in London or New York are having a bad time, those in Japan, Hong Kong or developing markets might be doing well. By spreading risk internationally, investors hope to offset the risk of a particular economy having a bad period due to macroeconomic factors, geo-political instability or an act of God such as a major natural disaster.
While this is still a relevant reason for an international investment strategy, it is becoming less important, with increased globalisation having led to far closer correlation between international investment classes and financial markets than was the case in the past. While 15 years ago there was little correlation between western developed markets and, for example Japan and Hong Kong, that is no longer the case. The fact that companies trade internationally and earn revenues in different countries, and the increased inter-connectedness of international financial markets has tightened correlation considerably. Nonetheless, it does remain a factor and is one major reason for international investment.
Better Range of Choice
Perhaps the more influential reason in the more closely correlated modern international investment landscape is that investing internationally simply provides investment managers with a wider choice from which to choose winners. While there will be hundreds or thousands of possible companies and investment instruments available to an investment manager on their domestic market, that becomes hundreds of thousands of options internationally. If they feel that a company listed on the stock exchange in Brazil or Singapore is undervalued to a greater extent than what is available at home they want to invest in that company and not be restricted by national borders when it comes to gaining an advantage over the competition.
Why do Institutional Investors Employ Currency Management Strategies?
Individual companies mainly use currency management to offset structural (costs in currency A and revenues in currency B) and transactional (timing differences between a contractual commitment and actual cash flows) exposure to currency fluctuation. Institutional investors, meanwhile, employ currency management to balance out currency risks in a portfolio of financial instruments with different currency denominations. It is also important to balance the risk that they may hold shares in companies that have significant structural or transactional currency risks, or exposure to equities indices where such companies have a heavy weighting.
For example, in 2013 the Nikkei 225, Japan’s benchmark equities index, registered a 45% climb in value. Over the same year the U.S. index the S&P 500 returned 32.39%. It would theoretically have been a better investment to have bought financial instruments tracking the Nikkei 225 over 2013. Clever investment managers that had read the situation correctly would have benefitted significantly by investing in the yen-denominated Nikkei in favour of the U.S. denominated S&P 500.
However, the yen also lost 13% of its value against the U.S. dollar over the same year. A U.S. hedge fund that had invested in ETFs tracking the Nikkei 225, that did not employ currency management strategies, would have lost 13% of that 45% profit to currency fluctuations. While the return would still have been better than investing in the S&P 500, it could have been significantly better.
Another U.S. hedge fund that had made the same call but had employed a currency management strategy to protect against a potential fall in the yen’s value against the dollar over the course of the year would have seen a smaller erosion of value than its competitor. Which will find it easier to attract future investors?
What is Currency Hedging?
Currency management comes in a wide variety of different strategies using different combinations of currency-based financial instruments, such as futures, options, forwards and swaps. How the exact strategy is formed will depend upon the specific nature of a particular investment portfolio and will be specifically tailored by currency management experts.
Currency hedging most commonly employs options or forwards for a particular foreign currency.
What is a Currency Option?
An option allows the investor to pay an upfront fee which buys them the right to a fixed exchange rate at a predefined point in the future. When the time comes the investor will choose whether or not to exercise their option, depending upon whether exchange rate fluctuations mean that it will be to their advantage or not. If the option is not taken the initial upfront fee is forfeit.
In the Nikkei 225 example, the investor may have paid the equivalent of 2% of the 13% drop in the yen’s value against the U.S. dollar to lock in the exchange rate as it was when the investment was initially made. As a result, the exchange rate fluctuation has cost the investment only 2% of its return rather than the whole 13%. If the exchange rate had gone the other way, or remained stable, the investor would have simply lost the 2% invested in the option. However, risk mitigation models will have shown that over the course of X number of investments involving currency risk that 2% is a price worth paying. It’s an insurance policy against currency movements going the wrong way.
What is a Currency Forward?
A currency forward differs in that the investor commits to a currency exchange transaction in the future at a locked-in price, rather than simply have the option to do so. How much a forward will be available for will depend upon how likely the market believes it is that the currency the forward is taken out on will move up or down by a certain amount by the time the forward’s execution date is reached. Like an option, the investor pays a premium on the current exchange rate as insurance against any significant fluctuations that would have a major impact on potential profits when the returns are realised by selling the investment at a future point. Unlike an option, the future currency transaction is locked in and not optional.