FX Managers’ Peer Group 2 looked at how to take a value-at-risk approach a step further.
The FXMPG2 convened for their summer 2014 meeting in San Diego in mid-September, sponsored by Deutsche Bank. The agenda was anchored by a sponsor presentation rules-based hedging which took a look at how to take a value-at-risk approach a step further by incorporating a view on currencies.
Deutsche Bank led the session on rules-based hedging and began by looking at the benefits of currency diversification and correlation effects, but also how each individual currency's contribution to overall risk must take into account its volatility. Applying value-at-risk modeling to this analysis, one can identify the greatest risk-reduction bang for the hedge buck.
• Cost does not equal value. Measuring the cost of hedging does not show its effectiveness or value. Instead, Deutsche Bank’s presenters suggested looking for example at risk reduction at given levels of option premium spend. To decide what level to hedge/spend, a company must have a clear view of its risk tolerance: a quantitative framework should be able to be calibrated for whether, for example, upside is worth less than downside.
• Please do take a view. If you agree that there are systematic returns in FX, as the presenters proposed, you should be open to a systematic, rules-based approach to medium-term hedging, meaning stepping away from "no view," market neutral hedge decisions. Signals to look for are (1) PPP and reversal to the mean (the example used was in the last several decades, the EURUSD has trades within a 20 percent band of PPP 71 percent of the time and periods outside of that have been short lived); (2) carry, i.e., high-yielding currencies don't depreciate as much as the implied forward indicates; and (3) momentum, meaning the past trend is likely to continue in the short to medium term. Each company can weight these three factors differently in the rules that will determine hedge decisions. A caveat: don't "over-optimize" based on historicals: consider in-sample/out-of-sample choices, recognize that volatility is a blunt instrument and that there are more ways than PPP to measure the long-term fair value of a currency.
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