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Quants and FX, a marriage made in heaven?

Currency risk | Quants and FX, a marriage made in heaven? Anthony Harrington

Equity fund managers have long had an ambiguous relationship with currency risk. If you are not a diehard FX trader, and sometimes even if you are, currency looks like the trading equivalent of a day at the races. You pays your money and takes your chances, and most of the time you lose.

If they had their wishes, most equity fund managers would love to be able to simply ignore FX as a factor. After all, they get measured against benchmarks that, by and large, take no account of FX risk, so this predisposes many of them to want to disregard it. However, depending on the state of your national currency, this is often not an option in volatile currency markets. Sudden, sharp FX movements can easily dwarf the single digit returns that many equity managers are trying to achieve in today’s flat-to-low growth environment.

Moreover, while it may be true that over a large-enough time horizon, say 30 years, FX movements will be self-cancelling, managers are not scrutinized over 30 year time frames. Their results are judged over a six- to 24-month period, and currency movements matter hugely over that time frame.

All of this makes a strong case for hedging out the currency risk, using either a passive hedge or an active hedge, where by “active” what we mean is active management of the scale of the hedge, varying it from near 100% down to zero depending on which way currency movements are going. With an active hedge the equity manager would expect whoever was managing the currency hedge to reduce the scale of the hedge, perhaps all the way down to zero when currency movements were going in their favor, and crank it back up again when matters were less clear or were clearly against them.

However, as I said, you’d only want to hedge if the general direction of the currency pair was against you. It can be argued, for example, that it doesn’t make much sense for UK pension funds to hedge their US assets since sterling has been depreciating against the dollar, year on year, for a while. Even here, however, intra-day or slightly longer-term movements can be quite sharp and if they come at precisely the wrong moment, can distort performance, depressing or exaggerating gains.

One FX house I spoke with recently pointed out that institutional clients of equity managers are getting very sophisticated at identifying the currency component in performance. If they find that a significant part of the gains being reported are due to off-benchmark currency risk they are inclined to ask awkward questions about risk management—even if the movements are in their favor.

There is another option, however, and that is to treat currency as a source of alpha (outperformance) in its own right. However, as Maria Heiden, who heads the FX quant team at Berenberg Bank, notes (see below) the idea of FX as a reliable source of alpha has been rather soured by the poor performance history of non-quant FX trading shops. “They’ve sent their sales teams all over the place selling the idea of FX as an alpha generator and generally failed to deliver, so that creates challenges for us. But we can show clients that our models will deliver outperformance over the course of a year,” Heiden says. Quant models are demonstrably better than human traders at exploiting patterns in data, and currency pairs are the perfect material for quant models to get their teeth into, she says.

Max Darnell, Chief Investment Officer at First Quadrant, which manages some US$17 billion for institutional clients, points out that none of the views they take on currency movements come from what might be called human intuition. “None of our views come from our gut, they all come from the models,” he says. So the moral of the story is: if you want FX alpha as a nice, non correlated growth element in your portfolio, find a good quant shop…

(Note: I spoke with both Darnell and Heiden as part of an article on FX passive and active layers for IPE Europe.)

Further reading on currency movements:



Tags: Bank of Japan , Berenberg Bank , BoJ , currency movements , currency risk , equity funds , First Quadrant , FX , FX risk , FX trading , Maria Heiden , Max Darnell , non-quant FX trading shops , quants , US assets , yen
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