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CFA® Level III · Derivatives and Risk Management · free lesson
Currency Management: An Introduction
For an international investor, currency moves can add to or wipe out the return on a foreign asset. This module splits foreign returns and risk into local and currency parts, sets a strategic hedge ratio from the investor's objectives, compares active currency strategies including the carry trade, and shows how forwards, FX swaps, options, proxy hedges and minimum-variance hedge ratios are used, including the extra problems of emerging-market currencies.
What you will learn
1. Calculate the domestic-currency return and risk of foreign investments by separating the local-currency return from the currency return.
- Domestic return = (1 + local return)(1 + currency return) - 1; the cross-product matters.
- Currency return is the change in the home-currency price of the foreign currency; invert quotes when needed.
- Variance of domestic return is about local variance + currency variance + 2 x correlation x both volatilities.
- For a riskless foreign asset, domestic volatility = currency volatility x (1 + R_FC).
- Currency dominates the risk of foreign bonds; for equities it can even reduce risk when correlation is negative.
2. Recommend a strategic currency hedge ratio and management approach, from passive hedging to active overlay, based on the investor's objectives, constraints and portfolio.
- The spectrum runs from passive hedging through discretionary hedging and active management to a separate currency overlay.
- Hedge more for short horizons, home-currency liabilities, low risk tolerance, bond-heavy portfolios and cheap hedges.
- Hedge less for long horizons, diversifying currency exposure in equities, expensive hedges and multi-currency spending.
- A 50% equity hedge ratio is a common regret-minimizing compromise.
- The benchmark reflects the investor's objectives; manager views affect only the permitted band.
3. Compare active currency strategies based on economic fundamentals, technical analysis, the carry trade and volatility trading, and identify the conditions in which each tends to work.
- Fundamentals (PPP, real rates, current account, fiscal position) drive long-run value but act slowly.
- Technical rules exploit trends and reversals over shorter horizons in liquid markets.
- Carry exploits the forward rate bias: buy forward-discount (high-yield) currencies, sell forward-premium (low-yield) ones.
- Carry returns are negatively skewed; losses cluster when volatility and risk aversion spike or rate gaps narrow.
- Volatility trading uses options to bet on realized versus implied volatility and can hedge carry.
4. Use forward contracts and FX swaps to set, roll and rebalance hedge ratios, measure roll yield, and choose option-based and other techniques that reduce hedging costs.
- Roll a forward hedge with an FX swap; each roll settles a gain or loss in cash.
- Selling a currency at a forward discount (higher foreign rate) is a cost; at a forward premium it earns positive roll yield.
- Annualized roll yield is about (F - S) / S divided by the forward's term in years.
- Rebalancing frequency trades off hedge accuracy against costs and cash flows.
- OTM options, put spreads, collars, seagulls and exotics cut cost but always leave some risk unhedged.
5. Apply cross-hedges, macro-hedges and minimum-variance hedge ratios, and discuss the special risks and costs of managing emerging-market currency exposure.
- A proxy hedge uses a correlated, cheaper or more liquid currency and carries basis risk if the link breaks.
- A macro-hedge protects the whole portfolio against a broad risk factor rather than each exposure.
- Minimum-variance hedge ratio = Cov(R_DC, R_FX) / Var(R_FX) = correlation x sigma(R_DC) / sigma(R_FX).
- Hedge ratios estimated by regression are unstable and need re-estimating.
- Emerging-market currencies bring high hedging costs, NDFs, thin liquidity, tail risk, pegs that break and contagion.
Module at a glance
- Domestic return = (1 + R_FC)(1 + R_FX) - 1; compute R_FX as the change in the home-currency price of the foreign currency.
- Currency dominates foreign bond risk, so bonds are usually hedged near 100%; equities often less, because currency can diversify.
- Hedging approaches run from passive through discretionary and active to a separate overlay; the IPS sets the benchmark and bands.
- Carry trades exploit the forward rate bias but are negatively skewed and unwind violently when volatility spikes.
- Selling a higher-yielding currency forward costs roughly the rate differential (negative roll yield); rolls create cash flows.
- Options, collars, seagulls, proxy hedges and lower hedge ratios cut costs but always keep some risk.
- Minimum-variance hedge ratio = correlation x sigma(R_DC) / sigma(R_FX); emerging-market currencies add NDFs, tail risk and contagion.
This free module has 5 lessons, 18 practice questions with full explanations and 1 essay case with a model answer.