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Why has risklab developed an investment process for hedging currencies? 

Ernst Riegel: We noticed that a large number of investors want, or often need, to hedge their open foreign currency positions. In recent years this has led to high hedging costs of up to 2% p.a. at times, especially in the US dollar area. The returns of institutional EUR-based investors have been greatly reduced as a result. This prompted us to consider whether there are ways to reduce hedging costs. 

Is this currently an important issue for your clients? 

Ernst Riegel: Given the low interest rate environment in the eurozone, many investors are looking for higher-yielding investment opportunities. The focus automatically falls on funds or asset classes that are very often denominated in US dollars. Just think of hedge funds, private equity funds or infrastructure funds. Investment opportunities from the US very often exceed the expected returns of their eurozone counterparts. But even the MSCI World Market Capitalized Index, often chosen as a benchmark for equity coverage, now has a US dollar weighting of around 66%. Or, if you want to invest in emerging markets hard currency, here too 78% of a classic benchmark index consists of US-denominated bonds. Therefore, it is safe to say that yield-oriented investors are pretty much ‘driven’ towards investments largely quoted in US dollars. 

Fine, but why should investors hedge their open currency positions? 

Ernst Riegel: There are many reasons for this. One key point comes from a risk-return perspective. In extreme cases, the currency risk can eclipse the profile of an investment, and thus change it negatively. So, as a general rule, investors should consider a currency hedge that maintains or even improves the risk profile of their investment. On the other hand, many investors are not permitted to hold any open foreign currency positions at all, or they may hold a limited position exposed to currency risk, but the allocation is often only 10–20%. Last but not least, we have clients who now hold a very large US dollar share because of the higher expected returns, but report their results in euros, and therefore simply want to reduce the currency risk. In all these cases, investors should choose an optimal hedge from a risk-return perspective. We have calculated the US dollar share for a moderately risk-conscious investor, and arrive at a ratio of 65%. 

But that sounds very high. Is it realistic? 

Ernst Riegel: Open currency disclosure is often prevented, on the one hand because the investor buys the fund in a euro-hedged version, or on the other hand because they invest in a fund that simply converts the underlying securities into euros, which means that currency fluctuations are not made apparent. The result is a currency risk that appears smaller than it really is. Here is a final example: suppose the investor has an equity ratio of 25%, and chooses the MSCI World Market Capitalized Index as a benchmark. With a neutral benchmark weighting, this can mean a US dollar ratio of 16.5%! If the fund is then quoted in euros, nobody can see this high US dollar share. 

So what is your solution? 

Ernst Riegel: At risklab, we would generally recommend buying funds that have a high proportion of US dollars, or are invested entirely in US dollar securities in the original currency, and carrying out the individually selected degree of hedging yourself. In all probability, the investor can then also save on hedging costs, since, in the case of currency-hedged funds, mostly static hedging is carried out via FX forwards, and in this case no optimisation takes place. 

What do you mean by optimisation? 

Ernst Riegel: For clients who hedge currencies strategically, we have developed an optimised hedging strategy whereby a freely chosen floor (level to which the currency can fluctuate) is defined for the hedge, essentially using options. This option strategy has historically resulted in significantly lower hedging costs over five- and ten-year periods than static forward hedging. 

How is that possible? 

Ernst Riegel: We have developed a model that very closely approximates the actual structure of the options market, with its implied volatilities. We can use it to optimise the desired hedging level at the planned target date very effectively, and thereby reduce hedging costs compared to a simple option purchase with a maturity and a floor. 

Can you give our readers an idea of the cost savings an investor can expect? 

Ernst Riegel: Certainly. To give a meaningful example, we have calculated a scenario from the perspective of a euro investor, assuming the following strategic asset allocation (SAA): 

1. 25% equities with MSCI World All Countries as benchmark (contains 58% USD)
2. 20% alternatives with hedge fund index as benchmark (contains 100% USD)
3. 10% US Treasuries (contains 100% USD)
4. 10% US Corporates IG (contains 100% USD)
5. 10% Global High Yield Bonds (contains 77% USD)
6. 25% EUR Bonds (contains 0% USD)

Overall, this portfolio has a US dollar ratio of 65%.

Over 14 years, the longest period for which we have data, this portfolio would have generated a return in EUR of 5.1% p.a. with a static forward strategy.

With our option-based currency overlay process, the portfolio’s return in euros would have been 5.5% with a 2% floor, and 5.9% with a 5% floor.

At higher risk? 

Ernst Riegel: Historically, no! Compared to the forward, the risk for the two floor variants is even slightly lower – by 0.2% (for a 2% floor) and by 0.1% (for a 5% floor) based on realised volatility. This finding is also reflected in the tail risk (based on 5% CVaR) for both floor variants, with minus 0.1% compared to the forward in each case.

That’s a nice outcome for the past – can we expect the same for the future? 

Ernst Riegel: Unfortunately we don’t have the proverbial crystal ball either, but if you consider the background of the outperformance of our option-based currency hedging compared to a simple forward strategy, an investor who strategically hedges foreign currency risks with the option-based process I have described has a very good chance of saving costs in the future as well. 

So what reduces the costs of the option strategy compared to the forward strategy?

1. The greater the interest rate differential between the currency to be hedged and the base currency, the more expensive the forward will be (in our example, the higher the USD interest rate compared to the EUR interest rate, the dearer the forward hedge will be for the eurozone investor). Here at AllianzGI, we note that inflation tends to be higher on the other side of the Atlantic (the economic cycle in the US is further advanced than in Europe) than on this side, so interest rates there are rising more strongly.
2. The second key question is: will the US dollar fall continuously over many years, more strongly than is priced into the market? If so, the forward strategy will have an advantage. However, if the dollar behaves more like it has done in the past, with periods of significant weakness but also with longer periods of appreciation (because, for example, the euro discussion flares up again due to the debt situation in Italy or Greece), then the option strategy has a good chance of being less expensive than the forward hedge.

In short, if in future the spot rate of the US dollar to the euro behaves only roughly similarly to the way it has in the past, i.e. shows similar volatility and momentum, then it is highly probable that the currency collar will have a clear cost advantage over the forward. Personally, I think that US interest rates will rise sooner than euro interest rates, given the economic cycle and the Fed’s historic response patterns. Bearing that in mind, now might be a good time to carefully weigh the pros and cons of the two strategies.

What about implementability and default risks? 

Ernst Riegel: Collateral management is used to hedge the risk of default, as with the forward strategy. AllianzGI is also able to track currency hedges centrally for multiple funds, for example within a master fund, via a sub-fund. To realise the strategy you just need an experienced team and a realistic model of the options market, in order to keep the costs of pure implementation as low as possible. 

To come full circle, now that you’ve explained all the ins and outs of this subject, what method of currency hedging do you recommend? 

Ernst Riegel: Funds, especially in the US dollar area, should be purchased in local currency so that you can control the optimal hedge ratio yourself and achieve transparency with regard to costs. Short-term hedging should be done using forwards. When it’s a question of strategic or long-term hedges, here at risklab we recommend option strategies that are optimised for the investment objectives, as these are very likely to generate lower costs than forwards.

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