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Derivative Overlay Strategies

September 30, 2020

Currency risk management for foreign fixed income investments

Investors buy foreign assets such as international bonds for the purposes of diversification, and more attractive credit spreads. However, investor holding assets denominated in foreign currencies must always consider currency risk. Identifying and managing this risk helps to isolate the risk and return of the underlying investment.

Another consideration when buying foreign assets is that the total return in local currency terms will be a combination of the return of the foreign asset and the change in the exchange rate. Some mandates may allow managers to take currency risk, while others may restrict such exposure. Depending on their market view and risk tolerance, managers can consider taking on currency risk as a source of alpha. Unlike credit risk, currency risk is not necessarily compensated by a risk premium, especially Developed Market (DM) currencies.

Currency forwards and cross-currency swaps can be used to manage the currency risk of foreign investments.

  • Currency forwards are typically used for investments that have a high degree of uncertainty in the timing and amount of future cash flows such as public equity or high yield debt. Given the cash flow uncertainty, this approach is based on the market value of the investment instead of the individual cash flows. Forward contracts with short dated maturities have the liquidity and low transaction costs necessary for efficient dynamic rebalancing to match fluctuations in foreign asset values.
  • Cross-currency swaps are commonly used for fixed income investments where the cash flows are known with a high degree of certainty. Hedging currency risk with a cross-currency swap effectively creates a synthetic local currency denominated bond by converting the bond’s foreign currency denominated cash flows or risk into a stream of local currency payments. Cross currency swap hedging strategies can be tailored for either active strategies or passive buy-and-hold fixed income strategies.

Cross currency swaps are Over the Counter (OTC) derivative instruments that involve exchanging interest and principal payments in two different currencies. Each side of the swap can be either fixed or floating payments. To facilitate the purchase of foreign assets, an initial currency exchange may be included. Similar to other OTC derivative instruments, a daily mark-to-market of collateral is required.

Offsetting currency risk for passive buy-and-hold portfolios (cash flow matching)

For investors with buy-and-hold mandates where bonds are held to maturity, currency risk can be offset at the cash flow level. When a foreign bond is purchased, a cross-currency swap is included to pay foreign coupons and receive payments in the domestic currency.

Since the cash flows of each individual bond are matched with a cross currency swap, this strategy requires little ongoing maintenance. Although the cash flows are matched, the interest rate sensitivities of the two assets are not equal. The market values of the cross currency swap and bond fluctuate over time as interest rates or credit spreads fluctuate.

Example: Canadian investor owns a USD $1 million face value

U.S. corporate bond with 2% coupon rate, paid semi-annually.

Offsetting currency risk for active portfolios (risk matching)

Offsetting currency risk at the portfolio level may be more suitable for investors with active mandates that have more turnover in their portfolios. This is because entering and unwinding individual cross-currency swaps for each position would be operationally burdensome. By offsetting the interest rate risk at different key rate durations (KRD), the portfolio’s sensitivity to foreign interest rate risk will be offset and the exposure will be transferred to domestic interest rate exposure.

Risk matching will require rebalancing as the portfolio’s composition and duration profile changes. Since this is performed at the portfolio level, risk matching should decrease the turnover for currency swap positions for granular portfolios with many holdings. Unlike a cash flow matching approach, risk matching offsets the foreign interest rate sensitivity, not the individual foreign cash flows.

Example: Canadian investor owns a portfolio of U.S. bonds

For a Canadian investor holding a portfolio of U.S. bonds, U.S. interest rate risk can be offset using a portfolio of cross currency swaps by paying fixed USD payments and receiving fixed CAD payments. Paying fixed in USD will act to offset U.S. interest rate risk while receiving fixed in CAD will introduce exposure to Canadian interest rates.

U.S. Key Rate Duration Exposure*

  2Y 5Y 10Y 20Y 30Y Total
Bond Portfolio

5,000

15,000

20,000

15,000

5,000

60,000

Cross Currency Swap: Pay Leg

(5,020)

(14,776)

(20,034)

(14,960)

(5,210)

(60,000)

Mismatch

(20)

224

(34)

40

(210)

0


Canadian Key Rate Duration Exposure*

  2Y 5Y 10Y 20Y 30Y Total
Cross Currency Swap: Receive Leg

5,649

15,941

20,242

14,642

4,986

61,460


Key rate duration measures a portfolio’s sensitivity to interest rates at different points on the yield curve. While offsetting portfolio duration will protect against parallel moves in yields, using key rate durations allows an investor to manage changes in the shape of the yield curve in addition to the level of yields.

Considerations

OTC instruments can be complex, which is why it is important to work with an experienced asset manager. OTC derivatives tend to have less liquidity than those that are exchange traded. SLC Management has extensive experience trading OTC derivatives, including cross currency swaps. OTC instruments also involve counterparty risk, for which we have established policies and procedures to manage credit risk of all counterparties.

At SLC Management, we focus on developing strong dealer relationships to secure competitive pricing across geographies. Cross currency swaps can be a useful tool to manage currency risk in foreign bond investments by transforming foreign coupon payments to domestic cash flows. This can be done by either offsetting the cash flows of each bond individually or by targeting interest rate risk at various key rate durations. Our clients benefit from cross currency swaps because they are highly customizable and well suited to managing the currency risk of foreign fixed income investments.


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