Q&A: Amundi’s James Kwok on currency risk

Are we entering a particularly volatile time in currency risk management?
Investors have become used to a period of diversification away from the US dollar and have favoured higher yielding foreign currencies for some time. The reason for this sustained period of dollar weakness was, firstly, the US current account deficit and secondly, the large amount of quantitative easing undertaken by the Federal Reserve Bank. So investors sold the dollar and bought foreign currencies but as the US economy began to improve, the dollar strengthened and investors found themselves overweight risky foreign currencies and underweight a healthier looking dollar. This has prompted a huge rebalancing exercise among investors now looking to hedge away some of the risk in their portfolios that is creating sustained volatility in the markets. The weak dollar mind-set has been here for around a decade, so the unwinding, or rebalancing, is going to take some time.

Can you give us any examples of specific risks you see in the market?
There has been a strong belief that energy prices will remain high and that demand for renewable energy will remain high in emerging markets. A significant number of projects have been financed with the US dollar, based on that belief. If we see falling oil prices and a slowdown in demand for renewable energy at the same time as a recovering US dollar, that could be a perfect storm for some of the corporates who have bet long on renewable energy financed by dollar investment.

What do local government pension fund managers need to weigh up when considering currency hedging?
Typically investors have global portfolios these days and through their global equity mandates will have exposures to foreign currencies. Sometimes their stocks may be performing very well but, taking the example of the Euro today, if the currency is being devalued then even though the stock is doing well, the global value of the investment will suffer compared to Sterling. Investors need to understand the correlation between an asset and its currency; they don’t always behave in the same way. If you understand how a stock performs in relation to its currency, you can take more informed hedging decisions. You also need to think about value. Determining whether a currency is under or overvalued will help decisions about how much of that currency you will want to own. You can arrive at your valuation in a number of different ways, there are various methodologies such as purchasing power parity, for example. But the  further away a currency gets from what you believe is fair value, the more confident you can be in getting a return on owning, or shorting that currency.

When you see clients’ portfolios for the first time, are they often running more currency risk than they need to be?
Without question. And there’s good reason for that. Pensions CIOs are often well trained and focused on managing asset classes. So they understand equities and fixed income inside and out but they won’t necessarily have as developed an understanding of how currency risk affects their portfolios. For example, there’s no academic research to support the idea that a growing economy will necessarily have a strong currency but investment managers are naturally drawn towards growing economies. Quite rightly so but there are currency risk implications to consider that can be managed.

What is meant by active and passive overlay?
Investment managers with less experience of currency risk management tend to opt for passive hedging. In this instance the client sets a hedging ratio with us of say 50%, for example, and then we make the relevant trades. As clients become more comfortable with the world of currency and currency risk management, they can opt to give us more discretion over the trades we make, in line with some agreed objectives. Active overlay might include more trades which are designed not just to hedge out risk but also to take advantage of opportunities we see in the market.

James Kwok is head of currency management, Amundi Asset Management.