If you are a pension fund manager, you will be aware that it is a sensible strategy to expose some of the portfolio to international assets.
This is a sound diversification strategy and it can help to boost the returns of the fund.
However, managing an international investment portfolio is complex for even the savviest of fund managers.
Managing currency risk is one of those complexities and it is surprising how many pension managers take a passive approach to this risk, given how volatile forex currencies can be.
It is therefore prudent to understand you can leverage currency markets to reduce risk.
This article covers how currency risk presents itself and what you can do to mitigate its effects.
Where international currency hits us
When managing currency risks in a pension fund, the first thing to understand is just where currency factors play a part – they are found in more places than one might expect.
The first place is investments in global equity priced in other currencies.
When you buy something outside your country, the chances are that you will need to convert your currency to the local currency or to USD to make the purchase.
Obviously, you will want to get the best possible conversion rate. If the forex exchange rate is poor then this will cost you.
Another place is through companies in which the funds are invested which source revenues outside the UK.
These companies will need to transfer profits or dividends back into the fund, so a favourable exchange will help grow the fund pool.
The last factor is where citizens transfer wealth to and from the UK as they emigrate and immigrate.
It is fair to say that when citizens add to or take from the fund, they will want to maximise their value.
Why volatility is bad
The forex market is the most liquid trading market in the world and also a volatile one.
Forex trading prices are in a constant state of flux, and these changes can be small or dramatic.
Regardless of the movement, they will affect the size of the pension fund.
Unfavourable movements in forex exchange prices can nullify or augment returns.
For example, let us assume the portfolio of overseas investments generated a 10% return in the past year but your base currency depreciated 10% in value – your potential return will be cancelled out.
This will impact the value of the pension fund’s global assets, meaning that future returns will need to be higher, or contributions increased to make up for the shortfall.
Currency volatility can also make things difficult for budgeting purposes – budgets need a level of predictability.
It is also fair to say that volatility can happen at the worst of times – such as during an economic recession.
In this instance you would have the dual whammy of not only having a suppressed fund size but an increasing number of people needing to draw from the fund due to financial hardship.
Options for hedging currency risk
Currency risk management is usually done using forex hedging.
If your portfolio consists of foreign currency denominated companies then you can hedge currency by having an equal and opposite investment in the currency.
The hedge works by providing an offset for any currency volatility in the fund. As a pension manager in the public sector, you generally have two options – forward contracts or options.
Forex Forward Contracts
A forward exchange contract (FEC) is a derivative that enables the buyer to lock in an exchange rate in the present for a predetermined date in the future.
This protects the business from adverse forex movements in future.
Forwards are best when cash flows are certain such as bonds since forwards lock you into the contract price even when the rate movement is advantageous to the business.
Foreign Forex Options
An option gives the right, but not the obligation, to exchange currencies at a predetermined rate for an agreed date in future.
Use options when cash flows are uncertain such as for equities.
A ‘put’ option protects the buyer from a fall in a currency, while a call option protects the buyer when currencies rise.
The benefit of such a strategy is that, for a premium, buyers can protect themselves from adverse movements.
Justin Grossbard is the co-founder of CompareForexBrokers
