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The Journal of Performance Measurement
Table of Contents
Vol. 16, #4 - Summer 2012
Letter from the Editor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Page 4
Letter from the Publisher . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Page 6
Rethinking Portfolio Risk in Asset Management
Charles T. Hage, Mohican Financial Management LLC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Page 8
Existing measures of portfolio performance are leading investors to allocate capital to the wrong funds by misrepresenting
risk. Current practice rests on false notions that risk can be treated separately from opportunity, risk can be derived from
return distribution, Gaussian tools are valid for any return profile, volatility of returns is a proxy for risk, and returns should
be adjusted for risk.
A New Choice in Multi-Period Investment Performance Attribution:
Effective Return versus Geometric Smoothing
Ronald J. Surz, PPCA, Inc.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 18
An ongoing challenge in multi-period performance attribution is getting numbers to add that do not add naturally. Specifically,
the benchmark return plus the sum of attributed effects (like selection and allocation) should equal the reported return. In
[Surz, 2010], I introduced a new method called “effective return” that produces the desired relationship by solving for component returns whose weighted sum equals the known rate of return.
The Journal Interview
John Longo, Ph.D., CFA, The MDE Group . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 23
Who’s Who in Performance and Risk Measurement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 28
Risky Business: Why Right-Risking, Rather than De-Risking, is Key for Pension Plans
Paul Sweeting, Ph.D., CFA, J.P. Morgan Asset Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Page 30
De-risking has become a key feature of the pension landscape. According to a recent survey of pension plan sponsors by Aon
Hewitt (2011), 78% of U.S. respondents thought it was prudent to reduce risk as funded status improved, while 69% of U.K.
respondents and 53% of continental European respondents stated that their longer term objective was to take less or no risk
in their plans.
Analyzing Diversification Effects, Sector Allocations, Market Conditions, and Factor Tilts in Advanced
Equity Beta Strategies: The Case of Efficient Indices
Felix Goltz, Ph.D., EDHEC-Risk Institute and
Dev Sahoo, EDHEC-Risk Institute . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Page 40
Capitalization-weighted indices are known to suffer from problems associated with high concentration; they fail to take full
advantage of the diversification opportunities offered by equity markets. A large number of alternative equity beta strategies,
which include low risk, fundamental, equal-weighted and other types of strategies, try to improve performance relative to
their cap-weighted counterparts. However, investors who are interested in such alternatives should obtain detailed information
on the sources of outperformance of such indices. In this paper we consider the question of performance drivers for a particular
strategy, Efficient Indexation, which draws on portfolio construction techniques to provide risk/return tradeoffs better than
those of their cap-weighted counterparts.
Flows and Woes: The True Costs of Spot Trading Policy
Matthew Lyberg, CFA, CIPM, Acadian Asset Management and
Alexander Dunegan, State Street Global Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 61
Kawaller (1992) demonstrates the financial risk when there is a difference between the settlement dates of an international
asset trade and the currency required for or generated from the asset trade. We extend Kawaller’s work to equity portfolios
with investor flows, finding that the foreign exchange risk becomes levered during investor withdrawals and de-levered during
contributions. We provide a general equation to describe the relationship and recommend the use of short dated currency
forwards to hedge the risk.
Flows and Woes: The True Costs of Spot Trading Policy
Kawaller (1992) demonstrates the financial risk when there is a difference between the settlement dates of an international asset trade and the currency required for or generated from the asset trade. We extend Kawaller’s
work to equity portfolios with investor flows, finding that the foreign exchange risk becomes levered during investor
withdrawals and de-levered during contributions. We provide a general equation to describe the relationship and
recommend the use of short dated currency forwards to hedge the risk. We then compare the cost of the forward
contracts to the cost of the unhedged risk over a five-year time series of equity and foreign exchange returns using
a Monte Carlo approach to simulate investor flows. We conclude that aligning settlement dates with forward contracts dramatically reduces risk at a negligible cost.
Matthew Lyberg, CFA, CIPM
is a Vice President and Senior Performance and Attribution Analyst with Acadian Asset Management. Previously,
Matthew worked at State Street Associates Currency Management. He began his finance career with State Street
Wealth Manager Services. He holds the CIPM certification, an M.B.A. with Distinction from Hult International
Business School, a B.A. in Russian Language and Literature from Boston College, and was a Fulbright Scholar to
Ukraine. Matthew is completing post-bac studies in mathematics.
Alexander Dunegan
is Managing Director and Head of Currency Management at State Street Global Markets. He is responsible for
all functions related to the firm’s currency management business. Since Alexander joined State Street, he has led
efforts in trading infrastructure development, product development, research and operations. He holds a Masters
in Finance from Boston College, a Master’s in Computer Science, and a Bachelor’s in Mathematics from Emory
University.
The authors wish to thank Mark Kritzman of Windham Capital, Mark Ginzburg, Ph.D., Professor Emeritus of
Azerbaijan Polytechnical Institute, Raymond Mui of Acadian Asset Management, and Jay Moore of Brown Brothers
Harriman for their guidance and advice on this article. Only the authors deserve credit for any mistakes.
INTRODUCTION
Kawaller (1992) demonstrates the financial risk when
there is a difference between the settlement dates of an
international asset trade and the currency trade required
to fund the asset purchase (sale):
“Consider a U.S. investor who decides to buy British
Securities. At the time of the trade, the price of the securities is fixed in pounds sterling; but given traditional
settlement and clearing conventions, the exchange of
dollars for sterling would likely be deferred for some
limited time (e.g., several days), exposing the trade to
the risk of sterling strengthening in the interim.”1
For an equity manager, the difference between the asset
and currency trades is most often a single day; most de-
Summer 2012
veloped market stocks have a three-day settlement cycle
compared to a two-day settlement cycle for currencies.
Assuming the currency trade is required to fund the
stock trade, trading currency and stock on the same day
would result in a failed trade. Many managers delay the
currency trade by a single day to avoid this problem and
ensure that both transactions are funded. However, the
risk exposures are determined by the trade date of the
asset; a single day delay of the currency trade results in
an active currency position relative to the benchmark.
We extend Kawaller’s work to equity portfolios with investor flows and find investor withdrawals lever up the
single day currency impact and contributions de-lever
the currency impact. Both directions result in an active
currency position away from the benchmark portfolio.
We start with a basic comparison between the performance impact of a 50% withdrawal and a 50% contribu-
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tion. We describe the relationship with a general equation and recommend the use of short-dated currency forwards to hedge the risk. We then compare the cost and
performance impact of the unhedged risk to the cost and
performance of the forward contracts over five years of
equity and foreign exchange returns using a Monte
Carlo approach to simulate investor flows. In the simulation, we use 1000 unique time series of random cash
flows pulled from a normal distribution with mean = 0
and standard deviation = 15% for six portfolios (AUD,
EUR, and JPY-based investors in the S&P 500 and
MSCI World Indices) from the period of October 31,
2005 to October 31, 2010.
INVESTOR WITHDRAWAL LEVERS
CURRENCY EXPOSURE WHEN CURRENCY
TRADED WITH ONE DAY LAG
Consider a JPY-based investor with a separate account
in a hypothetical passive S&P 500 fund with 0% divergence from the benchmark denominated in USD. On
Monday, the portfolio is worth 200 USD or 19,512 JPY
(JPY/USD rate of 97.56). Early in the morning she orders a 50% withdrawal. For this example we assume
0% equity return and 0% JPY/USD return on Monday.
The manager sells 100 USD in securities (9,756 JPY) to
fund the withdrawal. Table 1 illustrates such a situation.
Ideally, the manager would immediately convert the
USD proceeds from the stock sale to JPY on Monday.
However, the USD for delivery on the FX trade will be
on Wednesday, but the actual USD proceeds from the
stock sale will not reach the account until Thursday.
Given the trade-off, the manager delays the currency
trade for a single day, which aligns the FX and equity
trade settlements to Thursday. Without incurring any
explicit cost, the manager mitigated the certain operational risk of having an overdraft by aligning the settlement dates.
However, there is a real cost. The 9,756 JPY payable is
a fixed amount, exactly equivalent to the 100 USD proceeds from Monday. However, if USD depreciates on
Tuesday, there will not be enough USD available to purchase the 9,756 JPY required to fund the withdrawal.
The 9,756 JPY withdrawal creates a payable to the investor which must be funded by USD exposed assets.
This has the same market risk as a 100% JPY short position, which levers up the USD exposure to 200% on a
day when the USD depreciates 4.51% relative to JPY.
On the day the client withdrew the 9,756 JPY, the 100
USD was sold from the U.S. equity market. The manager has waited for a day to align the equity and currency settlements, so the 100 USD will trade at the
depreciated Tuesday market rate. The client is now
faced with a 440 JPY loss on the withdrawal. Simultaneously, the actual asset portfolio declines an additional
440 JPY from USD depreciation. The fixed currency
exposure against the smaller portfolio value results in a
single-day currency exposure of 200% USD for the portfolio. From translation exposure alone, the investor
loses -4.51% on her equity investment and -4.51% on
the JPY valuation of her withdrawn capital. The loss on
the cash, booked against the smaller portfolio value, results in a one-day currency impact of -9.01 percent. Figure 1 illustrates the effective currency exposures.
In the case of a contribution, the single day delay in the
currency trade creates a short foreign currency position
in proportion to the starting capital. We assume the
same 50% cash flow as the previous example, only this
Table 1: JPY Investor Perspective, 50% Withdrawal, USD Weaken -4.51%, Equity 0% Return
Assets
Cash Exposures
Total Performance
19,552
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Figure 1: JPY Investor Perspective, 50% Withdrawal,
USD Weaken -4.51%, Equity 0% Return
Portfolio Weight
JPY/USD Rate
time the investor contributes to the fund. Following
market conventions, the manager spends the JPY proceeds for equity trades on Day 1 and waits until Day 2
to convert the JPY contribution to USD. The currency
risk from the additional 100 USD stock investment is
offset by the 100 USD payable required to fund the purchase. Consequently, the portfolio has 300 USD in equity exposure but only 200 USD in currency exposure.
Table 2 demonstrates the accounting relationships and
resulting performance.
The USD currency depreciates, creating a 4.51% loss
on the assets. However, the JPY contribution converted
on Tuesday buys more USD than if it had been converted on Monday. By delaying a single day, the manager has taken a 33% short position in USD which
returned -4.51%, for a positive active contribution of
1.50 percent. The 4.51% loss on the assets and the
1.50% gain on the foreign denominated receivable result
in total performance of -3.00 percent. Figure 2 illustrates
the relative currency exposures driving these results.
Comparing the case of a 50% withdrawal to the 50%
contribution demonstrates the potential for the currency
risk from aligning settlement dates by a one-day lagged
trade to impact the relative performance among asset
managers. Suppose “Day 1” in our example was
10/23/2008, a day we purposefully selected for the contemporaneous equity and foreign exchange volatility. On
10/24/2008, the S&P 500 fell -3.45% and USD depreciated -4.51% relative to JPY perspective. Further, assume a single investor withdrew 50% capital from the
withdrawal example above (“Manager A”), while contributing the same amount to the contribution example
above (“Manager B”). As we see in Table 3, the investor
expects single-day performance of -7.80% from both
separate account passive managers. “Manager A” returns a loss of -12.31%, while “Manager B” returns 6.30 percent. The 6.01% performance difference is
attributable to an operational decision on spot trading
Table 2: JPY Investor Perspective, 50% Contribution, USD Weaken -4.51%, Equity and Return
Assets
Cash Exposures
Total Performance
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Figure 2: JPY Investor Perspective, 50% Contribution, USD
Weaken -4.51%, Equity 0% Return
Portfolio Weight
JPY/USD Rate
Table 3: Performance Impact of 1 Day Delay to Match Settlement
Manager A: 50% Withdrawal on Monday
Manager B: 50% Contribution on Monday
policy.
UNCOMPENSATED FX RISK: THE GENERAL
CASE FOR TRADING
Given equal flow amounts in the example above, we see
the 4.51% magnitude of the active currency loss for the
withdrawal is greater than the magnitude of the 1.49%
active currency. If the USD had appreciated instead of
depreciated, the withdrawal would have had an active
gain of 4.51% and the contribution would have experienced a 1.50% loss. The uncompensated exposure to
FX risk is then a function of the FX spot movement for
the day, the size of the flow, and the direction of the
flow. Observing this relationship, we have developed a
general case for investors to calculate their exposure to
the spot return during a client flow:
The Journal of Performance Measurement
withdrawal
The long and short term indicate the direction of the
client flow. In the case of a withdrawal (contribution),
the manager sells (buys) equity on T and transacts spot
on T+1, resulting in a single-day long (short) position
in the foreign currency. The spot return is simply the
return on the exposed assets. The flow amount can be
positive or negative. The absolute value operation on
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the flow amount relates the risk on the exposed capital
back to the total portfolio performance.
Applying the equation to Manager A, we observe a
-4.51% currency return and a 50% client outflow
booked on trade date.
For Manager B, a -4.51% currency return and a 50%
client inflow booked on trade date saw the following relationship:
The 6.01% difference in Manager A and Manager B performance is therefore 100% attributable to the operational decision to delay the FX spot trade by a single day
to match equity and currency settlement dates. Extending the equation to include the underlying equity performance, we have
Where:
Note the additive relationship of the uncompensated
FX_Trade_Risk term to the underlying asset performance.
The total return for Manager A would be:
Using a short-dated forward on trade date can be thought
of as either bringing the spot transaction forward a single
day or as hedging the foreign currency receivable from
the stock trades. For consistency with the general case,
we describe the relation as a hedge on the uncompensated risk.2 The relation between the short-dated forward approach and the uncompensated FX risk is then.
The approximate relationship is due to the performance
introduced by the forward points and transactions costs
required to convert the exposure on trade date. Applying
our proposal to the withdrawal example, we observe in
Table 4 that the single-day active risk is eliminated at
the cost of 1 bps to the portfolio.
Aligning trade and settlement dates of the asset and currency transactions with short-dated currency forwards
ensures the currency exposure remains consistent with
the manager’s desired target exposure throughout the
time horizon. In a passive portfolio, this results in minimizes tracking error to the benchmark.
The total return for Manager B would be:
SHORT-DATED FORWARDS FOR CURRENCY
RISK MANAGEMENT
To hedge the uncompensated risk, we propose using
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short-dated currency forwards to match the trade dates
of the currency and equity transactions. Instead of allowing the cash receivable (payable) from the stock sale
(purchase) to fluctuate with the market, the manager
trades FX and stock simultaneously. For those currencies with a settlement date less than the stock settlement
date (e.g., two days), the manager would book a oneday forward contract. The forward-traded currency
would settle three days from the trade date, meaning the
cash receivable (payable) from the stock trade would be
available on the same day of the physical currency delivery. The following equation describes the offsetting
impact of the short-dated forward.
The consequences of the uncompensated risk outlined
above are as severe as they are uncertain. Perhaps the
assumption that daily currency movements and the potential performance effects should average out in the
long run is one reason why this problem persists. A sec-
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Table 4: JPY Investor Perspective, 50% Withdrawal, USD Weaken -4.51%, Equity 0% Return
Assets
Cash Exposures
Total Exposure
19,552
-440
ond reason is that prior to the global financial crisis,
managers were more focused on alpha generation than
seemingly immaterial decisions on back-office operations. The extreme volatility across asset classes during
the financial crisis revealed the material impacts of operational decisions on investment returns.3 Finally,
clients are demanding unprecedented levels of transparency into their portfolios in the wake of the market
turmoil and massive cases of investor fraud. Each basis
point of performance is under scrutiny, and managers
must evaluate implementation processes for sources of
uncompensated risk. Recent research indicates that operational risks are a more important predictor of hedge
fund failure than financial risk.4 In short, managers
should expect a client inquiry for any uncompensated
exposures in the portfolio.
Surprisingly, the relative size of the investor flow is a
larger risk factor than the currency movement. In Table
5, the top row of the table below provides a range of investor withdrawals from the portfolio. The left-hand
column provides a range of spot returns. The intersection of a specific row and column represents the additional portfolio return in percent given the spot change
and flow amount.
As in the withdrawal example, a 50% withdrawal and -
5% spot return contribute an incremental -5% active currency return to the portfolio. For a foreign portfolio with
0 equity return and 50% investor withdrawal, the benchmark would return -5% while the passive manager
matching settlement dates would see -10% performance.
The same -5% currency move with a 75% withdrawal
would result in -15% active currency return. The benchmark would still be -5%, but the settlement matching
passive manager would return -20% for the day. If a
50% flow provides a 200% total currency exposure
(100% benchmark + 100% incidental exposure), and
75% provides 300% (100% benchmark + 100% incidental), then we can deduce the total currency exposure for
a given flow amount. Figure 3 illustrates the relationship.
INVESTOR CONTRIBUTION REDUCES
CURRENCY EXPOSURE WHEN CURRENCY
TRADED WITH ONE-DAY LAG
The contribution levers down the foreign currency exposure. In the case of a 50% contribution, the portfolio
would have 67% foreign currency exposure, 33% home
currency exposure, and 100% foreign equity exposure.
Note the 33% home exposure from the contribution creates a -33% short foreign exposure. The spot exposure
difference from the benchmark approaches a limit of
Spot Return
Table 5: Withdrawal: Percent Return Impact to
Portfolio Given Spot Return
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-50% as the portfolio contribution amount reaches 100
percent. For contributions greater than 100 percent, the
ratio slowly approaches -100 percent. A new portfolio
would have currency risk exposure equal to -100%,
since there is no beginning capital amount to offset the
single-day short local currency position. We capture this
term under the “Launch” column. Please see Table 6 and
Figure 4 for an illustration of the relationship.
For contributions, the function is bound to a -100% exposure, which only occurs during a portfolio launch. In
the case of withdrawals, the currency exposure of the
unsettled amount can be several orders of magnitude
larger than the remaining value in the portfolio. In Table
7, we highlight the maximum single-day losses a passive
manager would have incurred for given withdrawal levels in AUD, EUR, and JPY denominated portfolios over
the last 5 years.
SIMULATION
To quantify the return impact of the prevalent single-day
lagged currency trading, we convert the USD denominated S&P 500 five-year period from 10.31.2005 –
%
-80
%
%
-70
Flow Amount
Total Exposure to Foreign Currency
-60
-50
%
%
-40
%
-30
%
-20
%
-10
0%
Portfolio FX Exposure
Figure 3: 1 Day FX Trade Lag: Total Currency Exposure from Withdrawal
Benchmark Exposure
10.31.2010 to a non-U.S. denominated return series to
establish a benchmark return. We then construct a “settlement match” portfolio in which the manager delays
the currency trade by a single day. To simulate the cash
flows as a percentage of assets, we randomly draw the
cash flow amounts from a normal distribution with a
standard deviation of 15% and mean of 0 percent. We
then compare the daily return series of the benchmark
to the daily return series of the settlement matched (oneday spot trade lagged) portfolio, recording the daily
tracking error, minimum difference, maximum difference, and total ending value. We then repeat the simulation for a total of 1000 runs. We use the average
statistics of the 1000 runs as the basis for comparison.
We then repeat the same procedure, except the currency
transactions are executed on the same day using simulated forward contracts. To price the forward contracts,
we include the interpolated interest differential and the
additional transactions cost of the forward. We then
evaluate the distribution of returns of this approach relative to the base case. Figure 5 illustrates the results.
For an AUD-based investor in the S&P 500, the manager
incurred a mean 316 bps in annualized daily tracking
Table 6: Contribution: Total Return Impact to Portfolio
Given Spot Return
Spot Return
Flow Amount
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-5.00%
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Portfolio FX Exposure
Figure 4: 1 Day FX Trade Lag: Total Currency
Exposure from Withdrawal
Flow Amount
Uncompensated FX Risk
error over 1000 simulations by delaying the currency
trade a single day. Trading the currency with short-dated
forwards, in contrast, resulted in only 2 bps of annualized daily tracking error. The average maximum and
minimum daily differences for the single-day delayed
trade were 218 bps and -179 bps. The average maxi-
Benchmark Exposure
mum and minimum for the short-dated portfolio simulations were 6 bps and -6 bps. The average ending mean
benchmark difference for the five-year period in the oneday lagged test was -39 bps, while the short-dated forward simulations had a -1 bps average ending difference
with the benchmark. The histograms below illustrate
Table 7: Single-Day Losses for Passive Managers: 10/2005 - 10/2010
Figure 5: S&P 500
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the dispersion of the ending portfolio differences from
the benchmark for both the one-day lagged simulations
and the short-dated forward case.
The differences in standard deviations are significant.
The one-day lagged trading portfolio has a standard deviation of 4.48% around the -39 bps mean, while the
short-dated forward portfolio has a standard deviation
of 3 bps around a mean of -1 bps. A t-test (please see
appendix for tables) shows the means of both the oneday lagged portfolio and the short-dated forward portfolio are both statistically different from zero. However,
note the standard deviation of active returns over the
five- year simulation decreases from 4.48% to 0.03 percent. This sharp reduction in standard deviation supports our argument that trading currency on the sameday reduces the uncompensated risk. The VaR at 95%
confidence of the one day lagged strategy, assuming an
expected return of zero, is -7.77% compared to -0.07%
for the same-day currency trade.
Similar results are present in portfolios with broader currency diversification. Table 6, 7 and 8 provide our results from simulations of the AUD, EUR, and JPYdenominated MSCI World portfolios.
It is important to note that these results capture only the
end of horizon risk. The results are path dependent, so
it is likely that within the five-year time horizon the impact of single-day lagged spot trade may breach a
threshold larger than that at the end of the five years.
Our max and min daily returns only capture a single
day’s risk. If the currencies and investor flows exhibit
serial correlation, then several “bad days” in a row of
depreciating foreign currency combined with investor
withdrawals could prove catastrophic for a manager.
BENEFITS
A stable cost structure is the most compelling benefit of
managing the single-day risk from investor flow-driven
strategies with forwards. By trading short-dated forwards, managers avoid the risk of incidental leveraged
currency exposures and unpredictable single-day spot
market moves by paying forward transaction cost and a
single day of interest rate differential. In all simulations,
the cumulative transaction cost over five years from forward trading was approximately 1 bps. The interest rate
differential impact was consistently less than 5 bps over
the entire five years. This makes intuitive sense, considering that forward points are measured in thousandths
of basis points. Since any given trade is a percentage of
the existing portfolio, the transactions costs from the forward and the interest rate differential would be an even
smaller percentage of the overall portfolio. This cost
should be considered as the price of ensuring against the
potentially hundreds of basis points in uncertain outcomes from the potentially leveraged spot exposure generated from an investor flow.
Forwards are also easier to implement operationally than
options or futures strategies, which can also provide the
Figure 6
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Figure 7
Figure 8
same result. Asset managers and owners could trade the
forward contracts on current systems without the additional operational capital outlays necessary to account
for more complex derivatives. Further, the trading rules
for our proposed solution are similar to existing spot
trading rules, which results in a lower operational risk
than futures or options. In addition to the operational advantages, recent volatility has proven the depth of the
foreign exchange forward market. The Bank of International Settlements notes in their 2010 triennial report
that forward foreign exchange transactions rose 31% to
475 billion in daily volume.5
An added benefit of the low transaction cost and stable
The Journal of Performance Measurement
forward pricing is the manager can more closely monitor
the implementation costs of currency trading. When the
currency trade is aligned with the purchase of the underlying asset, it is easy for the investor and manager to
evaluate the implementation of the currency trade. By
timestamping the trade at the moment of execution, the
manager can evaluate the execution of the trade in the
context of prevalent market rates at the time of the trade.
Even with this operational control, the volume of trades
can make it difficult to manage the execution of each
single trade. This task becomes virtually impossible if
the trades are delayed a single day, as the trade then has
a 48-hour window of currency risk during which it can
be traded. For those outsourcing to a currency trade
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provider, this larger window introduces the risk they will
fail to achieve best execution. If the trade of the currency and the underlying assets are roughly at the same
time, the gain or loss on the implementation of the currency should tend toward zero. The single-day trade
horizon provides a more stable benchmark for evaluating the performance of these service providers.
The combined impact of the shift toward more international portfolios and a reallocation among investment
managers is that the spot trading volume is increasing
dramatically. In short, more managers are trading larger
amounts of spot so any frictions in the process are likely
to have a larger proportional impact on the portfolio.
In those cases where the amount of spot to be traded is
a function of unknown broker executions, the manager
should trade a large percentage of currency (e.g., 95%
of order) using short-dated forwards. On the following
day, the amount can be trued up using a spot transaction.
For managers wishing to capture the upside of the currency risk, Kawaller’s suggestion of using at the money
calls to capture the rise and ensure against the fall may
be more appropriate. One similar aspect of Kawaller’s
option solution and our forward solution is both depend
on a short time frame. The option premium is a function
of time and volatility. Controlling for the short time
frame, Kawaller notes the option would only be a preferable solution if implied volatility is low.
APPLICATIONS IN PRACTICE
Once a manager decides to avoid the uncompensated
risk inherent in settlement date matching, implementation questions arise. In the study above, we quantified
the impact of the risk using simulated flows. In practice,
the manager will likely develop a policy threshold above
which short-dated forwards will be traded. Our study
assumes a pro-rata liquidation or investment of the portfolio. In reality, there are an infinite number of permutations involving the relative weights of the flow, the
existing portfolio, and the target portfolio. We limit the
scope of this study to raising the problem of incidental
currency risk, providing a general case, and proving the
portfolio impact. During implementation, the manager
should consider the relative weight of the flow along
with the relative weights of the currency exposures.
While the benefit of trading short-dated forwards are
clear when the flow comprises 50% of the portfolio, the
utility may diminish for a flow that is only 2% of the
portfolio. We believe the general case provides a solid
starting point for this analysis.
It is important for the trading group of the investment
manager to match the spot / forward trading policy to
market conventions. Any country where the equity settlement window equals the currency spot trading window should be excluded from the short-dated forward
trading rule. Also, the manager must monitor the market
closely for any changes in these conventions. Similarly,
the manager should monitor the forward markets. It is
possible that a large interest rate differential could offset
the risk controlling benefits of the proposed trading
strategy.
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Passive managers, in contrast, should try to eliminate
the uncompensated FX risk completely. Active managers evaluated on a benchmark relative basis should
pursue the upside only if they have an opinion on the
single-day direction of the foreign currency move.
CONCLUSION
We established through a literature review, simple example, and simulations, aligning settlement dates by
waiting a single day to trade spot carries substantial risk.
The current market convention of a single-day lag
avoids the certain result of an overdraft. However, the
implicit cost of this approach as we define and measure
it is a function of the flow size and spot return for that
single day. We evaluated the cost of maintaining the status quo and trading short-dated forwards over a fiveyear period using random investor cash flows to provide
managers with a decision framework.
The wide dispersion of the simulation results indicate
the within-horizon variation is extremely high. Observing the histograms, we see the short-dated forward strategy results in values statistically different from zero. In
this case, the mean result is nonzero, but the standard
deviation is extremely low. Since the short-dated forward strategy standard deviation is effectively zero, we
believe our proposal successfully mitigates the singleday currency risk. The transaction cost and general case
framework will hopefully prove useful as investors
choose whether to endure this risk or eliminate it. Further, this framework can easily be adapted to evaluate
possible solutions, including the options strategy pro-
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APPENDIX
Statistical Summary of Simulation Results: Variance and Difference of Means Tests
posed by Kawaller and the forward strategy we propose.
Both have merit under different market and investment
mandates.
REFERENCES
Alexiev, Jordan, Jay Moore, and David Turkington,
“Share Class Hedging,” The Journal of Performance
Measurement, Winter 2009.
ENDNOTES
Kawaller, Ira G. Technical Notes A Novel Approach to
Transactions-Based Currency Exposure Management. Financial Analysts Journal, November-December 1992.
1
If we consider the forward trade as moving the spot conversion up a day, the exposure is offset and we do not need to relate the flow amount to the ex-post flow market value amount.
2
See Alexiev, Moore, Turkington for a review of currency
impacts on fully hedged portfolios.
3
Brown, Stephen, William Goetzmann, Bing Liang, and
Christopher Schwarz, “Estimating Operational Risk for
Hedge Funds: The Omega-Score,” Financial Analysts
Journal, Vol. 5, No. 1, 43-53, 2009. Winner of the Graham and Dodd Award.
Kawaller, Ira G., Technical Notes “A Novel Approach
to Transactions-Based Currency Exposure Management,” Financial Analysts Journal, November-December, 1992.
4
Brown, Goetzmann, Liang, Schwarz (2009).
Bank of International Settlements Report on Global Foreign
Exchange Market Activity in 2010. p. 6.
5
This article was reprinted with permission of The Journal of Performance Measurement. Summer 2012. All rights reserved.
Kritzman, Mark, The Portable Financial Analyst, Second Edition, Hoboken, NJ, Wiley 2003, pp 129 -158;
192 - 201.
Kritzman, Mark, “Strategies for Hedging,” Managing
Currency Risk, AIMR, Charlottesville, VA 1997
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