The Critical Role of Risk Control in Currency Management

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The Critical Role of Risk Control in Currency Management
June 22, 2007

Justin Simpson, Chris Callan

Foreign exchange as a standalone asset class, rather than a "hedged or not hedged" element of a portfolio, can create an attractive stream of stable returns uncorrelated to traditional asset classes. Yet the inherent volatility and frequent unpredictability of individual currency prices make a robust risk control framework key.

As the search intensifies for sources of investment return other than equities and bonds, currencies are rightly becoming viewed as a mainstream asset class in their own right. There is no doubt that the inefficiencies in these markets—partly the result of non-profit making participants buying and selling currencies—create significant opportunity for investment returns. But for many investment managers seeking to exploit these inefficiencies, they come at the cost of individual currency pair or market volatility shocks that can significantly impact performance.

What institutional investors need in order for foreign exchange truly to take its place as a meaningful portfolio allocation alongside stocks and bonds is a method of currency management with strong risk control that effectively manages volatility. By integrating both risk and return forecasts at the allocation stage, it is possible to build portfolios with stable volatility and explicit trade-offs between risk and return.

THE CASE FOR AN ALLOCATION TO CURRENCY

For institutional investors under pressure to meet liabilities by raising the efficient frontier of their portfolios, foreign exchange has great potential for putting substantial sums of money to work. At $1.9 trillion per day, the foreign exchange market's volume far exceeds the U.S. bond market's $821 billion per day and dwarfs the New York Stock Exchange's $46 billion per day (data as of December 2005).

Non-profit making participants such as central banks, multinational companies and people exchanging currencies for travel are responsible for much of this trade, which tends to mean there are exploitable inefficiencies in the market. These inefficiencies have persisted over a number of years and are well documented in academic literature. Furthermore, because the trading activities of these participants continue to grow in volume, market inefficiencies are unlikely to be arbitraged away by profit-maximizing players increasing their role in the market.

The size, liquidity and demonstrable inefficiencies of foreign exchange therefore differentiate it as a market with potential for capturing returns that places few limitations on investors in terms of allocation size. Indeed, the combination of ample liquidity and returns that have low correlations with traditional stocks and bonds means that it is practicable for institutional investors to improve risk-adjusted returns by diversifying into foreign exchange.

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