You have got the FX risk – we have got the hedge
FX risks make a significant contribution to the risk of your institutional portfolio. They represent additional risks and are not compensated by a risk premium.
We present the factors that are important for an efficient currency hedging strategy.
Focused currency manager
The appointment of a specialised currency manager brings many advantages for you, the institutional investor
- One dedicated contact for all your currency issues
- Transparent and flexible structure
- Timely and flexible adjustment of all currency positions
- Central liquidity management minimises cash holdings
- Increase of netting effects and thereby reduction of trading costs
The starting point for your individual FX hedging approach is your current portfolio.
We analyse your allocation in terms of investment vehicles, asset classes and foreign currencies.
The data is the basis for determining your ideal hedging strategy.
Defining the hedging strategy
Your optimal hedging strategy is as individual as your portfolio. To derive it, we use a systematic, four-step process:
1. filter: “safe haven” currencies
Foreign currencies that are negatively correlated to the portfolio allocation are excluded from the FX hedging strategy, as they can contribute valuably to diversification.
2. filter: hedging return and cross currency basis spread
We passively hedge those currencies whose hedging can generate a profit. This profit is due to the cross currency basis spread, which can be earned risk-free and thus offers an arbitrage opportunity.
3. filter: FX exposure by asset class
The interaction of asset classes and foreign currencies determines the design of the active or passive hedging strategy. The key parameters, among others, are diversification characteristics, liquidation possibilities and mark-to-market. For the main asset classes represented in institutional portfolios, this generally means:
- Fixed income is a less volatile asset class over the long term, and requires high hedging efficiency to ensure that currency volatility does not dominate the bond portfolio risk. The risk contribution of foreign currencies to this can be consistently high over time, so a passive FX hedging strategy may be appropriate.
- As equities are exposed to significant up and down movements over the long term, currency volatility in relation to this does not contribute dominantly to the risk content of the equity portfolio over the long term. In the short an medium term, however, the FX exposure can be a significant risk driver. An active currency hedging strategy can improve the risk-return ratio of the equity portfolio.
- Over the long time horizon, real estate is moderately volatile. As they are valued less frequently than exchange-traded instruments, there is a risk of hedging inefficiencies due to the lagged calculation of the FX exposure. Given the moderate volatility over the long term, an active FX hedging strategy would be sensible.
4. filter: individual constraints
Client-specific requirement are systematically taken into account in the currency hedging strategy. These can result, for example, from regulatory requirements (Solvency II, minimum tenor of hedging transactions etc.), balance sheet specifications (reserves, write-offs etc.), internal restrictions (minimum and/or maximum FX ratios, requirements from risk guidelines etc.)
In line with the identified optimal hedging strategy, appropriate benchmarks are defined in advance and thus adequately represent the mandate. At the same time, each benchmark is unambiguous and transparently measurable, as well as investable.
Once 7orca has analysed your FX data and derived possible hedging alternatives, the data is processed in accordance with the regulatory requirements and investment guidelines.
These will be presented to you during a comprehensive currency workshop. The workshop will also serve to clarify all your currency issues and gives you the opportunity to get an impression of how the Portfolio Management team and the Quant Research team work.
Active currency overlay
An active currency overlay offers you an attractive, asymmetrical risk profile in addition to high hedging efficiency: you can participate in rising foreign exchange rates and are hedged in the event of adverse exchange rate developments.
In addition to this market-adaptive hedging, 7orca’s solution is characterised by a quantitative and systematic investment process.
Our multi-model architecture, which uses the exchange rate and implicit hedging costs as input parameters, guarantees the strategic orientation of the overlay and a low trading frequency.
By introducing a machine learning model in May 2018, we have made lasting improvements to our proprietary model landscape.
Passive currency overlay
A passive currency overlay is useful if you want to constantly hedge your portfolio at a defined hedging level.
If FX volatility significantly increases the risk of your overall portfolio, this can be an effective hedging strategy.
7orca further improves the cost effective implementation through the tenor management. This enables us to derive the optimum tenor of the hedging instrument, taking into account all hedging costs with a proprietary algorithm.
Derivation of FX exposure to be hedged
The exact determination of your FX exposure is a daily recurring process.
We start with an inventory by determining the currency risks of the holdings that are reported daily.
The characteristics of liquid and illiquid asset play an important role in this process.
Especially the FX determination of illiquid assets is complex. This is due to the usually long valuation periods, a complex cash flow profile caused by capital calls and capital returns, potential liquidity restrictions and the volatility parameters of the underlying investment.
We exclude assets and portfolios whose currency risks should not be hedged.
Part of the process is also quality control, comparison with FX benchmarks and identification and correction of misallocated currencies.
Deviation bands and netting effects
Defined deviation bands are used to contrast transaction costs with the expected risk. This enables us to limit transaction costs to an economically reasonable level.
Netting effects are realised by consolidating the FX exposure of currency pairs across all segments, funds and currency areas and trading the netted FX exposure.
Synchronisation of currency hedging and procurement
To further reduce market price risks and transaction costs, 7orca synchronises the spot transactions in the underlying segments with the hedging adjustment in the overlay segment.
This enables us to eliminate FX risk immediately and cost-effectively at the time it arises.
Choice of instruments
With regard to the choice of hedging instruments, 7orca is not subject to any restrictions and uses the instruments that are most efficient under the given circumstances. These include both forwards and exchange-traded futures. In any case, we only use highly liquid and linear instruments.
Execution quality makes a significant contribution to the overall performance of a currency overlay mandate.
We therefore place a strong focus on the execution process. Our best execution process is based on the life cycle of a transaction and is composed of three phases: pre-trade, trade execution and post-trade.
7orca uses BestX software for pre and post trade analyses. This ensures that, regardless of liquidity providers and execution venues, a transparent analysis of transaction costs is carried out before trading and that the transaction is executed at the most attractive conditions.
7orca uses a systematic implementation project to manage the frictionless mandate setup.
Together with you we define milestones and set the schedule.
In regular meetings, the steering committee and the participants of the project group exchange information on the implementation progress.
Management of counterparty risk
The monitoring and management of counterparty risk is a key component of our FX programme.
When concluding forwards, the customer takes on a counterparty risk against the FX brokers.
Default risks arise from fluctuations in the market value of forward exchange transactions, some of which are substantial.
7orca monitors counterparty risks continuously and repeats the detailed broker due diligence on an annual basis.
7orca centralises liquidity in the overlay segment. Previously, this liquidity had to be kept available for the FX hedging of the underlying investment managers in the underlying segments.
We have established efficient processes to keep the average liquidity position in the overlay segment as low as possible.
Based on the characteristics of your investment vehicles, the allocated asset classes and the desired level of hedging, 7orca develops your optimal mandate structure.
Hierbei wählen wir für Sie die effizienteste und kostengünstigste Struktur. Zugleich vermeiden wir eine Überkomplexität bei der Ausgestaltung des Overlay-Segments.
In doing so, we select the most efficient and cost–effective structure for your needs. At the same time, we avoid over-complexity in the design of the overlay segment.
The FX exposure to be hedged is aggregated across all asset classes and sub-segments.
Currency report and data provision
The scope, content and level of detail of the performance report will be individually adapted to your needs.
As an additional reporting service, 7orca offers to include the performance contribution of the individual segments as well as the performance attribution relative to the defined benchmark. If required, 7orca can also prepare a cash flow forecast.
In general we can provide this information in all standard data formats.
Individual key figures can be automatically transferred to your management system via an interface.
7orca is your partner in FX matters
We are your sparring partner for your currency risks. With more than 20 years of experience in FX management, 7orca places its professional expertise at the centre of its activities for its clients.
A state-of-the-art IT landscape, proprietary investment processes and integrated software ensure an efficient risk management solution that is consistent with its characteristics.
As an independent asset manager, we select the most suitable implementation for you, without any conflicts of interest.
Please feel free to find out more in a personal conversation with us on +49 40 33 460 46 13.