Momtchil Pojarliev, deputy head of currencies at BNP Paribas Asset Management, talks about some of the misconceptions that exist amongst institutional investors regarding currency hedging.
For example, he explains that in the past, some firms have been unclear on the exact difference between absolute return strategies and active hedging.
In the former, the aim is to produce risk-adjusted returns that are as high as possible for a given volatility. The currency manager is allocated a notional amount of funds and can invest in any given currency to try and produce the maximum amount of returns possible. By contrast, active hedging is a tailored solution where the currency manager looks at the exposures of a particular client and they can only hedge, so it means that they can only sell the currencies that the client is already holding.
“So it’s different because let’s say you’re trying to address your FX risk and you invest in an alpha programme, that alpha programme is taking a whole bunch of benchmark risks. Let’s say the manager can buy the Turkish lira, they could make money or lose money, but it doesn’t matter because if you don’t have Turkish assets, that doesn’t solve your problem. And in the past I think people have been thinking that investing in currency alpha is actually addressing their FX exposure, but it’s not. The job of currency alpha is to provide a source of uncorrelated returns for your portfolio, but it has nothing to do with your FX exposure,” says Pojarliev.
Another mistake that some firms make, according to Pojarliev, is the assumption that passive currency hedging strategies are risk-free.
He comments: “Let’s say you have $100 billion of currency exposure and it was unhedged and you said, “I’m going to move to a 50% hedge ratio”, what it means in practice is you have to go into the market and buy $500 million against a basket of foreign currencies and that introduces a huge market timing risk. Let’s say you did that at the top of the US dollar in 2017. In 2017, the US dollar fell 10%, roughly speaking, so if you did it back then, suddenly you have $50 million in losses on your hedges. So the moment you move from no policy to passive hedging is a huge market timing risk, which very often people underestimate. And because people typically do passive hedging when the move has already happened, at the worst possible time, they suffer big negative cash flow on the hedges in the years ahead.”
In the extended interview, Pojarliev also talks about hedging trends more generally, and explains why he believes that the rising interest rate environment in the US will lead to more firms adopting an active approach to currency management.
The full interview can be viewed here: