» Using Currency Futures to Hedge Currency Risk
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the recent geopolitical uncertainties, the
foreign currency markets have been in ...
One simplistic view was to measure the
return in domestic currency ...
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Using Currency Futures to Hedge Currency Risk
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Topic: Currency
Sort Desciption: the recent geopolitical uncertainties, the foreign currency markets have been in ... One simplistic view was to measure the return in domestic currency ...
Content Inside: Using Currency Futures to Hedge Currency Risk By Sayee Srinivasan & Steven Youngren Product Research & Development Chicago Mercantile Exchange Inc. Introduction Investment professionals face a tough climate. Fixed income yields are at near lows. U.S. equity markets have been depressed for the past three years. Given the recent geopolitical uncertainties, the foreign currency markets have been in turmoil. What little returns that can be achieved by investment managers need protection. The investing public more and more is reaching out to global markets to make money and the issue of protecting investment returns from foreign exchange risk becomes critical. Explaining Currency Risk A key difference between investing in domestic and foreign assets is that the latter exposes the investor to a currency risk. Over the years, most investors have not been careful in characterizing this risk to returns from unhedged portfolios. One simplistic view was to measure the return in domestic currency terms and compare it with returns in local currency terms, and characterize the difference as the currency effect. The reasoning was that if the exchange rate remains constant from the time of purchase of the foreign asset to its sale, then the currency risk has had zero impact. On the other hand, if the domestic currency has weakened (strengthened) against the foreign currency, the exposure would result in a gain (loss). In August 1998, the Association for Investment Management Research (AIMR) argued that the use of changes in spot exchange rates (over the investment period) as a measure of the influence of currency risk on foreign asset returns was misleading. AIMR preferred an alternate approach, one that involved splitting the currency effect into components: expected or known effect captured by forward premium or discount; and unexpected or surprise effect as defined below. Lets assume that we are measuring foreign asset returns for a U.S. investor. Expressing exchange ra ...
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