By Tindaro Siragusano
When considering managing currency risk you are essentially faced with two choices: you can leave your risk unhedged or you can choose to hedge your risk. Whichever choice you make, you remain exposed to risk: either the market risk of the underlying portfolio, i.e. the risk of losses caused by a depreciation of the foreign currency in which your assets are denominated, or the hedging risk of high liquidity requirements for the hedging instrument in the case of an appreciation of the foreign currency.
Therefore, the most effective way of dealing with the problem is to manage currency risk dynamically, and hedge your currency exposure according to market conditions: in periods of currency appreciation leave it unhedged and in periods of depreciation hedge it.
The critical elements of successful currency hedging are market timing and direction: how do you identify the start of a trend in a currency, and is the trend appreciating or depreciating? Quantitative trend following systems answer this question very systematically. Mathematical models give the assurance that they will repeat their results as long as the input is the same, i.e. if markets move the same way in the future as they did in the past and the system detected the trend properly it will do so in the future. Even if we know that markets never move in exactly the same way in the future as they did in the past there will be similarities and, therefore, a mathematical model gives you the confidence that results will be similar.
At Berenberg, we use a multi-model framework in order to exploit sustainable market trends in different time clusters (short, medium and long term). Applying different models to distinct time clusters results in increased stability of generated returns and reduced volatility of the aggregate position.
Trend following systems will always lack performance in sideward moving markets. To control performance in non-trending markets, our models are able to detect range markets and allow us to turn positions to neutral. However, when it comes to risk management, a sideward moving market is not the main risk. The main risk is a strong trend.
Finally, the single input parameter into currency risk management should be the exchange rate itself, because it is the highest level of information aggregation: only if the price moves it is the right time to act and decide whether to leave foreign currency exposure unhedged to gain currency profits, or to hedge your exposure to protect the portfolio from a depreciating currency.
Looking at macroeconomic data such as inflation, GDP or international capital flows does not actually manage the risk, because only if the exchange rate itself moves is there a need to react. By following this approach, it is easier to make the decision whether to hedge or not to hedge in market conditions that are driven by the macro forces such as the European financial crisis and the Ukraine/Crimea conflict. All we know for sure is that the future is uncertain. Exchange rates will have periods of appreciation and periods of depreciation, we will see strong trending markets and have times of sideward movements. In a world of change, risk management has to be flexible and able to react to changing market conditions, as this happens from time to time. Only a systematic, trend following strategy fulfills this requirement and protects investment returns.
Tindaro Siragusano is head of asset management at Berenberg
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