an optimal hedge ratio discussion-one size does not fit all

Ennis Knupp + Associates vox 312 715 1700 10 South Riverside Plaza, Suite 1600 fax 312 715 1952 Chicago, Illinois 60606-3709 www.ennisknupp.com

AN OPTIMAL HEDGE RATIO DISCUSSION –

ONE SIZE DOES NOT FIT ALLIntroduction

As institutional investors increase their allocations to non-domestic securities, the associated currency risk becomes an increasingly pertinent subject in need of addressing. Our advisory position on currency hedging is that for most clients, the drawbacks can be significant and the benefits over the long-term may be small and are not guaranteed. There are no easy answers in regards to currency management. In this paper we provide background on the currency market, develop a decision making framework as it pertains to whether or not to hedge currency, and share our thoughts and experience in regards to implementation should clients determine hedging currency is appropriate given their specific circumstances.

Contained within Appendix I is a currency hedging decision matrix which summarizes relevant issues for consideration as it pertains to hedging currency. In addition, we’ve developed an Excel-based tool 1 which encompasses the points outlined in the currency hedging decision matrix. This tool allows the user to weight the importance of each factor resulting in a “suggested” hedge ratio. As with any tool such as this, it should be used as guidance in developing an appropriate hedge ratio. Contained within Appendix II are two case studies, detailing institutional investors with unique circumstances, which helps to illustrate the functionality and usefulness of this Excel-based tool.

1 The genesis of EK’s Excel-based currency hedging tool can be traced back to James Binny and his paper entitled “The optimal benchmark for a currency overlay mandate.” In this paper Mr. Binny outlines key currency hedging considerations. In developing our currency hedging tool, we have expanded upon Mr. Binny’s framework and methodology. We would like to thank Mr. Binny for his thoughts and comments which were extremely helpful throughout the development of this paper.

Currency overlay is a typically used phrase in currency management, which to us means any strategy that involves management of (or attempts to protect) a portion of an investor’s portfolio from adverse currency movements. An example might be having a currency overlay program which involves an investor’s non-domestic equity portfolio. Furthermore, the currency overlay program might be a passive one where the investor has a static 50% hedge ratio in place (i.e., half the non-domestic currency exposure within the equity portfolio is hedged back to the domestic currency base). One could also have an active currency overlay. This could take the form of implementing a dynamic hedge ratio or the management of a static hedge ratio with the ability to take on limited active risk in order to achieve profits. Generally, an active overlay has the primary concern of managing risk and secondarily, making money.

The Currency Market

Daily liquidity in the currency market has been estimated at $3 trillion and is significantly larger than any other capital market. Participants in this market include central banks, corporations, equity & bond investors, hedge funds, and tourists. Transaction costs are relatively small when trading in the most liquid currencies. The majority of transactions in the market are done through derivatives such as forwards where there is no initial outlay of capital, as opposed to the spot market where capital is exchanged. Investors are able to gain market exposure while their assets are invested elsewhere.

ENNISKNUPP Independent advice for the institutional investor

©2009, Ennis, Knupp & Associates, Inc. 2/19

The most widely used instrument in currency management is a forward contract. This is a customized agreement which is traded over-the-counter (i.e., no formalized exchange where there is a party in between the buyer and seller guaranteeing proper settlement). Counter-party risk exists anytime one is dealing in an over-the-counter market. In theory, two parties exchange one currency for another at some date in the future. The agreed upon price, or forward rate, is set in the present and represents the current period arbitrage-free exchange rate. The forward rate is a poor predictor of the future exchange rate. In practice, no “principal” is exchanged. The only exchange between the two parties is the net result (a gain for one party and a loss for the other) over the life of the forward contract. The calculation of the forward rate is a function of the interest rate ratio between two currencies and the current spot price.

Futures contracts are sometimes used in the management of currency exposures. These securities are standardized, by contract size and expiration date, and trade on formal exchanges that eliminate counterparty risk. Options and swaps can also be used to implement hedging strategies. However, the forward contract reigns supreme, in terms of use, largely due to its customization and relative cheapness to transact. Given the current market environment, where counterparty risk is of increasing concern, it is not unimaginable to believe exchange-traded instruments such as futures and options, rather than forward contracts, begin to play an increasing roll in hedging currency risk.

Currency Hedging

Two questions of particular interest to plan sponsors are:

At what non-domestic allocation level should an investor consider implementing a hedge?

What is the appropriate (optimal) hedge ratio?

Neither question is easily answered. What we can do is help our clients:

Understand the currency risk imbedded within their portfolios

Develop a customized framework for evaluating this risk

Implement a policy addressing this risk

The conventional optimal hedge ratio definition is the percent of non-domestic currency exposure that when converted back to domestic currency minimizes total portfolio volatility. The optimal hedge ratio can also be defined in terms of maximizing return. The optimal hedge ratio is different depending on the objective and will be different when performing analysis at the non-U.S. equity level versus the total portfolio level.

Chart 1, on the following page, depicts institutional investors’ practice with regards to hedging currency. The majority (69%) of survey participants do not hedge their foreign currency exposure. The next largest category is a 50% hedge position and included 17% of respondents.


Chart 1 - Hedging Practices of Institutional Investors

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Source: Mellon Analytical Solutions

Academic literature supports multiple non-domestic allocation thresholds that would warrant a hedging policy. The results of these studies tend to be time-period dependent with little regard paid to unique investor circumstances. As it pertains to an optimal hedge ratio, research over the last 20 years has supported a completely unhedged portfolio, a completely hedged portfolio, and multiple points in-between. What academics (and practitioners) can agree on is that currency is a source of risk.

Our review of existing literature leads us to believe there is no single non-domestic allocation that, once passed, signifies the need for hedging currency – especially not one that can be uniformly applied across all investors. Ultimately, there is no clear path with regards to the management of currency. The longer the time horizon the less risky currency exposures appear and the less currency risk needs to be managed.

Currency Volatility 2

Within this section of the paper we analyze currency risk in an attempt to identify the hedge ratio which minimizes volatility from both a non-

2 The historical analysis (as shown in this paper) of currency impact on portfolio volatility is from the perspective of a U.S.-based investor. The minimum portfolio volatility hedge ratio will be different when viewed from a non-U.S.-based investor’s perspective. In this paper we lay out considerations, beyond historical volatility analysis, that we believe are important to the hedging decision irrespective of where the investor is domiciled.

domestic equity allocation point of view (Chart 2) as well as from a total portfolio point of view (Chart 4). In the latter case, we assume a simplistic portfolio consisting solely of fixed income (30%) and equity (70%) investments. This analysis 3 is based on 20 years of historic returns and the covariances and correlations that are derived from these historic returns.

Chart 2, on the following page, shows volatility within the non-U.S. equity portion of a portfolio across various hedge ratios. Volatility is minimized by hedging 88% of non-domestic currency exposure back into the U.S. dollar. Across the full range of hedge ratios, volatility remains within a 1.6 percentage point range. Using recent five, ten, and fifteen-year return data, the optimal hedge ratio (defined as the ratio that minimizes volatility) is 100%, 92%, and 73%, respectively. This implies that the time period used can be a significant determinate of the optimal hedge ratio.

The minimum risk hedge ratio is not stable over time. Pertaining to non-U.S. equity, Chart 3 shows the hedge ratio that minimizes risk over rolling five-year periods.

3 All historical analysis (as shown in this paper) of portfolio volatility levels resulting from various hedge ratios assumes uniform hedging across individual currencies. We note, it is possible (and available to institutional investors) to “optimally” hedge individual currencies, resulting in different hedge ratios per currency.


Chart 3 - Non-U.S. Equity Portfolio Volatility-Minimizing Hedge RatioRolling Five-Year Periods (January 1988 - September 2008)

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Chart 4 shows volatility within a total portfolio context across various non-U.S. equity allocations and hedge ratios. The line showing the most volatility reduction benefit realized by hedging currency is the scenario which assumes 35% of the total portfolio is allocated to non-U.S. equity (i.e., 50% of total equity exposure). In this

scenario total portfolio volatility is minimized by hedging 91% of non-domestic currency exposure back into the U.S. dollar. Interestingly, a 100% hedge ratio actually increases volatility (albeit marginally). Volatility remains within a 0.4 percentage point range across all hedge ratios and across all allocations to non-U.S. equity.

Chart 2 - Non-U.S. Equity Volatility Across Hedge Ratios (January 1988 - September 2008)

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Chart 5, on the following page, examines the minimum volatility hedge ratio at the total portfolio level assuming a 35% U.S. equity, 35%, non-U.S. equity, 30% fixed income asset allocation. Again, we look at rolling five-year periods. The majority of the periods show that a

100% hedge ratio minimizes total portfolio volatility. It is important to note that neither Chart 3 nor Chart 5 depicts the marginal impact to volatility that is potentially achieved by incrementally higher hedge ratios.

Chart 4 - Total Portfolio Volati lity Across various Non-U.S. Equity Allocations and Hedge RatiosNon-U.S. Equity as % of Total Portfolio(January 1988 - September 2008)

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Within both Chart 2 and Chart 4, much of the volatility reduction benefit is gained by going from a 0% hedge ratio to a 50% hedge ratio. Beyond 50%, further volatility reduction is negligible. While it is interesting to view the volatility reduction benefit of hedging currency at the non-U.S. equity level, it is more important to view currency volatility at the total portfolio level. At the total portfolio level, there is little divergence in volatility across the full range of hedge ratios.

Hedging currency exposure is not an automatic volatility reduction exercise. Analysis of historic data (over a 20 year period) does show a modest volatility reduction benefit to hedging currency exposure. We stress that this type of analysis (i.e., using historic standard deviations and correlations) is highly time period dependent, and as such, should be used as one potential input into the overall hedge ratio decision-making process. Forward-looking measurements of volatility and correlations are unknown, so the future volatility-minimizing hedge ratio is impossible to ascertain. As we detail in the next

section, there are additional considerations when determining an optimal hedge ratio.

A Holistic Approach - Additional Considerations

In our literature review, we found many articles that addressed currency risk from a rigorous mathematical underpinning (similar to the quantitative approach outlined in the previous section). What was lacking in many of these papers was a holistic and practical approach to define, and make tangible, this currency risk that is embedded within most investors’ portfolios. Below we outline additional considerations (beyond purely attempting to minimize total portfolio volatility) when deciding whether to hedge currency exposure.

Chart 5 - Total Portfolio Volatility-Minimizing Hedge RatioRolling Five-Year Periods (January 1988 - September 2008)

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Adverse cash flows

Any hedging of a portfolio has the potential to create cash flow events, which could be significant. The U.S. dollar depreciated

substantially in 2003 as Chart 6 indicates. The return difference between a passively managed unhedged non-U.S. equity portfolio and a 100% hedged portfolio was over 24 percentage points.

Assume an investor had a 20% allocation to non-U.S. equity and fully hedged the currency exposure (back into the U.S. dollar). In doing so, the investor would have experienced realized cash outflows on the order of nearly 5% of total portfolio assets to cover hedging losses as the U.S. dollar continued to decline throughout 2003. Exactly equal, offsetting unrealized gains would have accrued within the underlying managers of the non-U.S. equity component.

Paying out nearly 5% of total portfolio assets must have been rather disruptive (as well as distracting) to those who lived through this real event. Having a 50% hedge ratio would have amounted to nearly 2.5% of total portfolio assets

being paid out to cover hedging losses. If an investor has little tolerance for unplanned cash flows, then hedging currency is probably not a good fit.

We further illustrate the impact of potential adverse cash flow events, as a result of hedging. Chart 7 depicts rolling three-year cash flows, as a percent of a portfolio’s non-U.S. equity allocation, resulting from both a 50% and 100% hedged position. Over the three-year period ending December 2004, an investor would have paid-out the equivalent of 23% and 46% of their non-U.S. equity allocation to cover losses resulting from a 50% and 100% hedged position, respectively.

Chart 6 - Non-U.S. Equity Index (20 Years 9 Months through September 2008) Return Differences 0% Hedged versus 100% Hedged

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However, investors have options to reduce the “pain” associated with cash flow volatility resulting from hedging activities. Normally, cash flow events (as a result of hedging activity) can be structured such that funds settle on regular intervals (i.e., four times a year) which allows for limited planning. A cash pool can be set-up and used as a buffer to absorb positive and negative flows. This pool can be equitized through the use of a futures overlay; effectively reducing cash drag on performance. Also, the investor can attempt to minimize the impact of cash flows by timing the maturity of hedging cash flows to coincide with regular inflows as a result of normal portfolio operation.

Peer group risk

It was noted earlier in this paper that 69% of survey participants did not hedge their foreign currency exposure. If peer group risk (i.e., the potential for generating a return that is significantly dissimilar from peers) is a priority,

then an unhedged position would be desirable as it will not result in large deviations from peers.

Time horizon

Having the luxury of a long investment horizon can make the risks associated with currency appear less looming. Chart 6 showed that over a 20 year perspective there was a modest benefit associated with bearing currency risk. We stop short of assuming a currency risk premium, but instead we illustrate that over long periods of time, the U.S. dollar (relative to a market weight basket of MSCI ACW ex-U.S. Index currencies) has remained relatively constant. Over shorter periods of time, U.S. dollar movements have been volatile. Assuming an investor has a relatively short time frame, this would be an argument in favor of hedging currency risk. Although, if the timeframe is sufficiently short, one might want to question the appropriateness of investing in “risky” assets such as equities.

Chart 7 - Rolling Three-Year Cashflows20 Years 9 Months Ending September 2008

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Minimizing Regret

Numerous academics and practitioners have studied the pros and cons of hedging a non-domestic currency portfolio. Some have come to the conclusion that hedging is a worthwhile endeavor, but that an optimal hedge ratio is elusive. A 50% hedge ratio has been portrayed as the “minimum regret” position. Specifically, it is the position that reduces remorse that can occur from selecting a hedge ratio that in hind-sight, proved not to maximize return and/or minimize volatility. This hedge ratio reduces potential extreme return volatility relative to either an unhedged portfolio or a 100% hedged portfolio. Minimizing regret and minimizing volatility are two separate goals that typically (but not necessarily) lead to separate hedge ratio decisions. While not inherently wrong, we believe some portion of investors employing a 50% hedge ratio do so to minimize regret as opposed to minimizing volatility.

Liability Matching

As investors move further away from U.S. dollar-denominated investments a potential issue arises regarding the mismatch of liabilities and assets. Specifically, liabilities tend to be denominated in

domestic currency, yet a large portion of assets are denominated in non-domestic currencies. The aim of many institutional investors is to fund various commitments or obligations. Intertwined with this goal is preservation of purchasing power. If domestic currency falls, purchasing power falls. From a long-term fundamental perspective, exposure to non-domestic currency denominated assets should provide a natural hedge to reduced purchasing power as a result of domestic currency weakness. At times, non-domestic currency denominated assets provide extra return when pension plan liabilities are increasing. We explore these issues in greater detail.

The Citigroup Pension Liability Index is a measurement of the increase or decrease in a plan’s liabilities. As interest rates fall, bond prices increase as do pension liabilities, hence the high correlation witnessed between the Barclays Capital Aggregate Bond Index and the Citigroup Pension Liability Index as shown in Chart 8. Currency Impact is the return difference between Non-U.S. Equity (Unhedged) and Non-U.S. Equity (Hedged). This measurement isolates currency return, specifically the U.S. dollar relative to the MSCI ACW ex-U.S. Index basket of currencies.

Chart 8 - Citigroup Pension Liability Index Correlations (January 1995 - September 2008)

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Over the nearly 14 year period (the extent of the Citigroup Pension Liability Index) there appears to be no correlation between the growth in pension liabilities and U.S. dollar value relative to other currencies. The implication of this analysis

is that there is little relationship between growth in liabilities (via the discount rate) and currency movements, thus the decision to hedge or not has limited bearing on liabilities.


We take our analysis a step further and provide rolling three-year correlations between the Citigroup Pension Liability Index and Currency Impact (Chart 9). When looking at rolling three-year periods there does appear to be a modest relationship between rising liabilities and U.S. dollar weakness. One of the key long-term fundamental drivers of currency return is interest rates. As a country’s interest rate falls, its currency becomes less attractive. Investors tend to seek yield, and as a result, capital generally flows to areas of the world where interest rates are relatively higher. From roughly 2000 on, the U.S. experienced generally declining interest rates which was a prevalent fundamental factor

in the decline of the U.S. dollar relative to other currencies over the same time period. This U.S. dollar decline benefited non-U.S. equity returns, provided the investor was unhedged. At times, an unhedged non-U.S. equity portfolio provided a counterbalance to increasing liabilities. As interest rates fall and liabilities rise, having an unhedged non-U.S. equity portfolio provides the potential for an investor to participate in out-sized returns generated by non-U.S. equity managers resulting from U.S. dollar weakness. As stated earlier, the relationship is modest and appears to be strongest in a normal global interest rate and risk environment.

The prior analysis provides only limited insight into a pension plan’s ability to pay benefits. The risk remains that an investor’s liabilities tend to be denominated in domestic currency and that a strong domestic currency environment erodes the value of non-domestic currency investments. As such, an argument can be made for hedging

should an investor expect to raise cash to fund liabilities through frequent selling of non-domestic currency denominated investments. More specifically, hedging may make sense if sales of non-domestic currency denominated investments are known to transpire over a relatively short time period as these assets do not have the luxury of

Chart 9 - Three-Year Rolling Correlation (January 1995 - September 2008) Citigroup Pension Liability Index versus Currency Impact

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riding out potential short-term currency fluctuations. From a long-term fundamental perspective, exposure to unhedged non-domestic currency assets should provide a natural hedge to erosion of purchasing power. Over the short-term, currencies can move far away from fundamental valuations, potentially reducing or negating this benefit. The investor’s time horizon becomes a critical component in determining the importance of this liability mismatch which is an inherent aspect of investing outside of one’s home country.

Implementation of Hedging Programs

The following section deals with implementation of a hedge ratio and many of the common issues/concerns that tend to arise. The actual management fee for implementing a passive currency hedge is typically 0.05%. In addition, there are transaction costs which tend to range from 0.08% - 0.15% (assuming a normal liquidity environment).

Counterparty risk

Lines of credit (and appropriate documentation) must be set-up between the investor, currency manager, and counterparties. Counterparty risk exists between the investor and those parties taking the opposite side of forward contract positions. The overriding risk is that the counterparty defaults, leaving its obligation to the investor unfulfilled. An International Swaps and Derivatives Association (ISDA) Master Agreement must be employed between the investor and various counterparties for any transactions in the over-the-counter market. Appendix III delves into more detail regarding implementation issues as it pertains to ISDA agreements.

Identifying hedging methodology

An investor has two methods by which to implement a currency hedge, 1) hedge exact exposures held in the underlying portfolio, or 2) hedge benchmark exposures (assumes underlying managers do not differ materially from their benchmark). Much of the portfolio’s currency risk will be minimized under the second methodology, although the first methodology is more accurate (and more complex). In our survey of the currency market, the second methodology appears to be a more common practice. Managers that hedge or utilize currency management as a tool for generating excess return should be identified and likely, excluded from any overall hedging program as not to counteract the manager’s investment strategy. We note, it is much more prevalent for international bond managers to manage currency exposure than it is for equity managers.

Rebalancing the hedge

It will become necessary to rebalance hedging positions given market movements in the underlying portfolio. Frequency of rebalancing can be triggered as a result of a predefined misalignment threshold being breached (i.e., the hedged Japanese yen exposure is more than two percentage points greater than the weight of the yen in the reference benchmark). Alternatively, an investor may wish to rebalance back to the predefined hedge ratio reference benchmark country weights on a monthly basis.


Use of proxy hedging

Forward contracts do not exist on certain currencies and for some of those countries where forward contracts exist, transaction costs may be high making hedging prohibitive. Proxy hedging can be employed to combat this problem, whereby a more liquid currency is used as a substitute.

Typically, the “proxy” currency is within close geographical proximity to the target currency or they share common characteristics such that the correlation of the two currencies is high.

Summary

Whether or not an investor decides to hedge some portion of their non-domestic currency exposure, we believe it is important to address this specific risk within the investment policy statement. There are no easy answers as it pertains to currency hedging. We believe, for the majority of our clients, hedging does not make sense. The risk reduction case is marginal, at best, and is no guarantee. The cash flow implications can potentially be disastrous. What we can do is assist our clients in navigating the issues surrounding currency hedging, such that informed decisions are made based on particular circumstances and needs.

Shane Schurter February 2009


References: Black, F., (1989) “Universal Hedging: Optimizing Currency Risk and Reward in International Equity Portfolios,” Financial Analysts Journal Volume 45, No. 4. Binny, J., (2001) “The optimal benchmark for a currency overlay mandate,” Journal of Asset Management Volume 2, No.1. Froot, K., (1993) “Currency Hedging over long horizons,” NBER Working Paper No.4355. Gardner, G. W., and Wuilloud, T., (1995) “Currency Risk in International Portfolios: How Satisfying is Optimal Hedging?” The Journal of Portfolio Management Spring 1995.

Kritzman, Mark., (1992) “What Practitioners Need to Know…About Currencies,” Financial Analysts Journal

Volume 48, No. 2. Michenaud, S., and Solnik, B. (2006 - Draft) “Applying Regret Theory to Investment Choices: Currency

Hedging Decisions,” HEC-School of Management, Paris. Perold, A. F., and Schulman, E. C., (1988) “The Free Lunch in Currency Hedging: Implications for Investment Policy and Performance Standards,” Financial Analysts Journal Volume 44, No. 3.


Appendix I: Currency Hedging Decision Matrix (Indicated Hedging Policy, All Else Being Equal)

View on Currency Risk Premium Indicated Action No View Theoretically Indifferent / Err toward not hedging (avoid

administrative burden and costs (although minimal))

Expected Risk Premium Don't Hedge

No Expected Risk Premium Hedge View on Future Currency Appreciation/Depreciation No View Theoretically Indifferent / Err toward not hedging (avoid

administrative burden and costs (although minimal)) Believe Domestic Currency Will Appreciate Relative to Foreign Currency Basket Hedge Believe Domestic Currency Will Depreciate Relative to Foreign Currency Basket Don't Hedge View on Net Impact of Currency Movements on Volatility No View Theoretically Indifferent / Err toward not hedging (avoid

administrative burden and costs (although minimal))

Increase Volatility Hedge

Decrease Volatility Don't Hedge View on Meeting Cash Flow Needs

Averse (highly sensitive to potential cash outflows) Don't Hedge

Indifferent (not sensitive to potential cash outflows) Indifferent/Hedge View on Paying Hedging Fees

Very Sensitive Don't Hedge

Less Sensitive Indifferent/Don't Hedge View on Handling Program Complexity

Very Sensitive Don't Hedge

Less Sensitive Indifferent/Don't Hedge View on Matching Liabilities to Consumption Basket

Very Sensitive Hedge

Less Sensitive Don’t Hedge View on Minimizing Regret

Very Sensitive Hedge 50%

Less Sensitive Theoretically Indifferent / Err toward not hedging (avoid administrative burden and costs (although minimal))

View on Peer Group Comparisons

Very Sensitive Don’t Hedge

Less Sensitive Hedge Ability to Sustain Short-Term Currency Losses

Short-term view and/or horizon Hedge

Long-term view and/or horizon Don’t Hedge


Appendix II: Case Studies

Below we detail two investors that have unique circumstances, leading to potentially differing outcomes as it pertains to currency hedging. We utilize our Excel-based currency hedging tool which provides a “suggested” hedge ratio. The tool applies a level of attractiveness to various hedge ratios given the investor’s preferences. We believe this level of attractiveness feature is highly useful as it defines sensitivity (i.e., how much more or less attractive one hedge ratio is relative to another) as opposed to solely identifying one hedge ratio as the best course of action.

Case Study 1 - Healthy Pension Plan

Healthy Pension Plan (HPP) is doing well, relative to peers. Its funding ratio is above average. There is a stable stream of contributions which is slightly more than benefit payments. While HPP is in a good cash flow position, the ability to maintain this position and continue to provide timely benefit payments is paramount. Non-U.S. equity exposure is 30% of HPP’s overall asset mix. They view this allocation as prudent, but realize currency volatility is a large risk embedded within their plan. Currency exposure is unhedged.

HPP’s investment staff consists of a CIO and a mid-level investment analyst. In addition, staff and trustees are sensitive to investment fees, and expect consistent results from their investment managers. Peer group comparisons

are examined extensively, and are an important measure of success. Many of the trustees believe the U.S. dollar has been depressed for so long that it is due for a multi-year rally. Staff and trustees believe the academic evidence for a currency risk premium is inconsistent, and as such, assign no return expectation due to exposure to foreign currencies.

On the following page we show a likely weighting scheme that is based on the circumstances of HPP. Notice the factors (i.e., consideration points) follow closely with those listed in Appendix 1. As such, Appendix 1 serves as a useful guide detailing the indicated course of action resulting from the viewpoints of each independent factor. A useful feature of the Excel-based tool is that it aggregates independent viewpoints/considerations into a unified result.

In this scenario, the suggested hedge ratio is 30%. Notice though, the level of attractiveness across other hedge ratios. A hedge ratio of 0% - 50% yields nearly the same level of attractiveness. All else being equal, our recommendation would be to maintain a 0% hedge ratio, thus avoiding the potential for large realized cash outflows resulting from adverse currency hedging positions. In addition, HPP avoids increased costs and increased plan complexity.


Level of Attractiveness Relative to Other Hedge Ratios

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Case Study 1 - HPPFactors for Consideration & Corresponding Importance (Total weight must add to 100%)

View On: Importance of this View ( %)Expected Currency Risk Premium 0%No Expected Currency Risk Premium 0%U.S. Dollar Strength 20%U.S. Dollar Weakness 0%Net Impact of Currency Movements on Volatility 15%Meeting Cashflow Needs 15%Paying Hedging Fees 10%Handling Program Complexity 10%Matching Liabilities to Consumption Basket 0%Miniziming Regret 15%Peer Group Comparisons 15%Ability to Sustain Short-Term Currency Losses 0%

Total % 100%

Suggested Hedge Ratio (% Hedged) 30%


Case Study 2 - Liquidity Constrained Foundation

Liquidity Constrained Foundation (LCF) has relatively high exposure to non-U.S. equity (roughly 50% of its total equity allocation). In addition, LCF has substantial exposure to illiquid asset classes. Cash contributions have declined and may soon impair LCF’s ability to maintain a level of spending similar to recent years past. The primary goal of LCF’s investment program is to earn a return in excess of inflation. The Board of Directors have little use for peer comparisons and concentrate primarily on absolute return and the ability to continue to support existing program funding.

Recent down-side market volatility combined with reduced cash flow has left the Board of Directors concerned that stated foundation goals may not be met. To that end, LCF has established a conservative stance regarding investment income. Budgets are increasingly scrutinized and stress-tested. The ability to plan for future cash expenditures is highly valued in this market environment. The Board is fully aware the U.S. dollar’s general decline over the last three-to-five years has been a significant contributor to non-U.S. equity performance. As such, this currency tail-wind leads many of the Directors to believe there is a premium allotted to investors willing to assume currency risk. LCF’s general view on the U.S. dollar is that in the near-term there may be sustained strength, especially if the global economy continues to falter, but over the longer-term the U.S. dollar is expected to weaken as a result of increased money supply and expected

government intentions to allow real interest rates to remain low.

LCF has multiple investment professionals on staff. The Board analyzes the impact of investment decisions (i.e., investments made versus those not chosen) and, on occasion, they express a certain level of regret when the results of previous decisions are not optimal relative to other paths potentially taken. The majority of LCF’s expenditures are within the U.S. The Board views their non-U.S. equity exposure as a natural hedge against U.S. dollar weakness as well as providing a certain degree of purchasing power preservation. They believe currency volatility adds risk to the overall investment program and that all else being equal, this risk would normally be managed similar to other risks within the portfolio.

In this scenario, the suggested hedge ratio is 0%. The level of attractiveness steadily declines as the hedge ratio increases. LCF’s liquidity concern, affected in the model through the high level of importance placed on meeting cash flow needs, is the primary driver of the downward sloping line (as shown on the following page).


Level of Attractiveness Relative to Other Hedge Ratios

0%

20%

40%

60%

80%

100%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Hedge Ratio

LOW

-

(at

tract

ion

level)

-

HIG

H

Case Study 2 - LCFFactors for Consideration & Corresponding Importance (Total weight must add to 100%)

View On: Importance of this View ( %)Expected Currency Risk Premium 10%No Expected Currency Risk Premium 0%U.S. Dollar Strength 0%U.S. Dollar Weakness 15%Net Impact of Currency Movements on Volatility 15%Meeting Cashflow Needs 45%Paying Hedging Fees 0%Handling Program Complexity 0%Matching Liabilities to Consumption Basket 0%Miniziming Regret 10%Peer Group Comparisons 0%Ability to Sustain Short-Term Currency Losses 5%

Total % 100%

Suggested Hedge Ratio (% Hedged) 0%


Appendix III: International Swaps and Derivatives Association (ISDA) Master Agreement

An ISDA agreement serves the primary purpose of specifying contractual terms such as how the parties would aggregate the amounts owed each other (i.e., netting gains and losses). If the investor does not currently have an ISDA agreement in place, or little experience negotiating this type of contract, the process can be long – as little as three months or as long as 18 months depending on specific circumstances. Furthermore, multiple ISDA agreements will need to be executed if transactions are spread amongst multiple counterparties. Our experience working with investors who are negotiating these types of agreements has been that the first contract takes the longest to execute and that subsequent contracts tend to be executed much faster. An attorney experienced in these negotiations is highly recommended.

The investor may have an alternative to personally negotiating ISDA agreements, depending on the currency manager employed. The currency manager may have umbrella agreements with their executing banks (i.e., counterparties). If so, the currency manager may be able to include the new investor’s mandate underneath this umbrella agreement. Typically a signed copy of the investment manager agreement, proof of portfolio size, and possibly articles of incorporation (if applicable) are needed. Under this option, there is also the potential added benefit of the currency manager having the ability to trade with known counterparties (as opposed to the investor selecting the counterparties) who may have specific strengths trading in certain markets.

an optimal hedge ratio discussion-one size does not fit all

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