White Paper: How important is Currency?

Currency Background

Currency markets are one of the largest and most liquid in the world. Economic variables like interest rates, economic growth, inflation and productivity are some of the drivers of currency movements making predicting currency difficult.  Extreme fluctuations in currency can have a meaningful impact on client returns and can also impact the ability of fund managers that employ currency hedging to pay distributions in the future. This has been the case in more recent times for Australian investors.

In Australia, 2008 was a dismal year for investors. We saw a huge devaluation of the Aussie dollar against the US dollar from a high of 0.9794 on the 15th July to a low of 0.6013 on the 27th of October. This amounted to a 38% decline in just over 3 months. The chart below demonstrates just how large the fall was and how volatile currency markets can be.

The Australian dollar didn’t just drop against the US dollar (USD).  In the same period it fell 45% against the Yen and 22% against the Euro.  The reasons behind the drop were a combination of rapidly declining interest rates, the unwinding of the AUD YEN carry trade, the decline in both demand and prices for commodities and a ‘flight to safety’ to the USD.

How important is Currency?

Normally, small currency fluctuations over time are easily managed and would not typically have a material impact on investors’ funds and portfolios.  But large movements, such as the ones experienced in 2008, will have an impact.

This paper will discuss the two main effects of significant currency fluctuations:

• The cash flow effect, and
• The performance effect

The Cash Flow Effect

Many of the funds that are routinely used in portfolio construction use currency hedging to remove risk associated with the movement of the Australian dollar.  Funds that will typically be 100% hedged include international fixed interest funds, international property funds, some international equity funds and global listed infrastructure.

If a managed fund hedges out the effect of a fluctuating currency, then the usual mechanism for this is to use currency forward contracts. If forward contracts are in place in a portfolio then this is what happens:

The key part of the table above is the highlighted cell.  If the Australian dollar devalues, then the forward contract makes a loss which must be settled in cash.  In the normal course of events this is not a problem.  The manager simply settles out of cash in the portfolio or sells assets.  This settlement in cash becomes a problem when:

• The devaluation of the Australian dollar is very large over a short period so that a large amount of cash is needed; and
• Some or all of the assets in the portfolio are illiquid.

The other key part to understanding this problem is to appreciate the quantity of the cash needed.  Fund managers have sometimes needed to find enormous amounts of cash.  To illustrate, it’s best to work through an example.

Numerical Example – AUD against USD 3 month forward contract.

In a forward contract the following may occur:

• The Australian fund manager agrees to sell Australian dollars and buy USD today (T0) at the ‘spot’ rate (today’s transaction rate).
• The fund manager simultaneously agrees to reverse this, that is sell USD and buy AUD, in 3 months time (T90) at the forward rate.

The forward rate is calculated using the AUD/USD spot rate and the two risk-free interest rates for each currency. This is a 90 day example, where at T0 we sell AUD and buy USD, and at T90 we sell USD and buy AUD.

Note: We have selected values that were applicable in July 2008 for this example.

So the Australian fund manager has agreed to buy USD and sell AUD at 0.9379 in 3 months time.

At the forward date the transaction unwinds itself.  The profit/loss of the transaction is shown in the table.  For simplicity, we have used a USD amount of $1,000,000 at the end of the forward contract.

The calculation is simple. At the end of the forward contract the fund manager is selling USD 1m at the forward rate to get AUD (1,000,000/0.9379) = AUD $1,066,118.

If the fund manager doesn’t have USD1m to sell at the end of the contract because there have been no sales from a portfolio, then they also have to buy USD at spot.  If we use 0.6500 as the spot price, this would cost $1,000,000/0.6500 = AUD $1,538,461. That is, it costs $A 472,343 net to settle the contract. When the AUD goes from 0.9500 to 0.6500 in a three month period, then the currency forwards lose AUD $472,343 for every $1m hedged. This was the situation in 2008.

The table below shows the cash flows associated with unwinding the forward contract above (0.9379) at different T90 spot rates.

To repeat, in this example, which mimics the market in the 3rd quarter of 2008, a fund manager with a portfolio of fully hedged USD assets would have had to find almost half a million dollars in cash to settle every million dollars hedged through a currency forward.  A fund manager with a $1 billion portfolio would have had to pay out close to $500 million in cash to settle the contract.

Of course not all fund managers had fully hedged portfolios or 3 month forward contracts.  Many had longer dated forwards or some of their portfolios unhedged.

Effect on Portfolio

There are several potential effects on a portfolio, depending on how it is structured:

• When there is a cash loss from currency forwards, there is also a matching upward valuation in the assets.  The value of the fund does not change.  The difficulty is that the portfolio value is paper profit and the payment of cash is a real payment.
• Assets may have to be sold to settle the forward contract.  In a ‘hybrid’ portfolio that has both liquid and illiquid assets, this might alter the proportions of each.  The fund might become overweight in illiquid assets.  Most funds have limits around the proportions of each.
• The cash that needs to be paid may use up the existing liquidity in the fund, including the normal cash buffer that is used for redemptions and any accumulated income.
• The forward loss may be accounted for as a trading loss.  Income flowing into the fund will be set against the loss and not paid out as distributions.
• The fund, if it is able, may have to borrow to fund the cash settlement.  Income coming into the fund would then go to paying off the loan.

Where there has been the extraordinary circumstances of both market illiquidity in property and fixed interest, coupled with the enormous fall in the Australian dollar, it is not surprising that there have been some funds that have had to alter the redemption schedule or distribution practice due, at least in part, to the effects of the negative cash flow on the currency forward contract.

The Performance Effect

You have seen from the example above the possible scale of the effect of extreme currency movements.  Of course not all funds are fully hedged. International equity funds or those funds that are perceived more liquid behaved differently to the cases we have discussed above:

• International equity funds are liquid.  If cash is needed the manager simply has to sell assets.
• International equity funds can range from fully hedged to fully unhedged. Typically, most would not hedge more than 50%. There are both passive currency managers and active currency managers. The focus for international equity funds is not just the cash flow effect in very volatile markets – it is the currency effect throughout all market cycles.  An appendix has been attached to the back of the paper highlighting the different approaches adopted by ‘International Equity’ managers on the Lonsec approved list.

In summary, it is important to be aware of the effects of currency movements along with asset sector movements. Even skilled equity fund managers find predicting the direction and size of exchange rate moves difficult, therefore using currency as a source of alpha can be fraught with danger. In many cases the currency effects swamp the underlying market effects and, as we have seen, can also lead to changes in redemption and distribution policies for some Funds.