Research Note Andreas Steiner Consulting GmbH February 2011

Currency Hedged Return Calculations

Introduction
As of first quarter 2011 it is probably not necessary to elaborate on the importance of currency risk. Significant movements in major exchange rates like the USD or EUR took place just recently and have had a major impact on the performance and risk characteristics of international portfolios. Nevertheless, we see a contrast between the importance of the currency risk factor in modern investment management and its treatment in portfolio analytics like performance attribution and risk budgeting. Part of this can be explained by conceptual complexities: currencies are not just another asset class, but a risk exposure embedded in any assets and therefore affecting the overall portfolio in non-trivial ways. This research note addresses one particular aspect of currency risk analytics, namely the calculation of hedged asset currency returns. Such calculations are used in paper portfolios like benchmarks and generally ex ante performance and risk analytics.

Unhedged Foreign Asset Returns

In order to prepare a framework for the discussion of currency-hedged asset returns, we will first analyze unhedged asset returns. Let us consider an investor with the base currency CHF that invests a certain amount X in an asset denominated in USD for a certain period of time. We use the following notation

X0, CHF X0, USD X1, CHF X1, USD

Capital in base currency at the beginning of the investment period Capital in asset currency at the beginning of the investment period Capital in base currency at the end of the investment period Capital in asset currency at the end of the investment period

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Electronic copy available at: http://ssrn.com/abstract=1759204

The situation can be illustrated graphically as follows

Start of investment period t0 Asset Currency USD X0, USD

End of investment period t1 X1, USD

Base Currency CHF

X0, CHF rA, CHF

X1, CHF

What we are interested in is to calculate the CHF return of the USD asset rA, CHF. The calculation is basically a three step procedure 1. Convert the amount to be invested from base currency to asset currency and buy the asset. 2. The asset incurs capital gains and losses in its currency over the investment period. 3. Sell the asset at the end of the investment period and convert the proceeds back into base currency.

Graphically, the three steps are

t0 USD X0, USD

t1

X1, USD

CHF

X0, CHF

X1, CHF

The formulas involved in the three steps are S0 S1 rA, USD Beginning spot exchange rate of the asset currency relative to base currency Ending spot exchange rate of the asset currency relative to base currency Asset return over investment period in asset currency
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Electronic copy available at: http://ssrn.com/abstract=1759204

t0 X1, USD = X0, USD (1 + rA, USD) USD X0, USD

t1 X1, USD

X0, CHF / S0

X1, USD S1

CHF

X0, CHF

X1, CHF

The calculations in the three steps are

1. X0, USD = X0, CHF / S0 2. X1, USD = X0, USD (1 + rA, USD) 3. X1, CHF = X1, USD S1

It follows that rA, CHF can be expressed as

1 + rA, CHF = X1, CHF / X0, CHF = X1, USD S1 / X0, CHF = X0, USD (1 + rA, USD) S1 / X0, CHF = ( X0, CHF / S0 ) (1 + rA, USD) S1 / X0, CHF = (1 + rA, USD) S1 / S0 and finally 1 + rA, CHF = (1 + rA, USD) (1 + rS)

with rS as the spot currency return over the investment period. Note that since S1, USD/CHF is not known at the beginning of the investment period, currency risk as an additional source of investment risk enters the equation. From this exact formula, we can derive a well-known approximation 1 + rA, CHF = 1 + rA, USD + rS + rA, USD rS rA, CHF rA, USD + rS From this approximation, we can clearly see the nature of currency risk: the return of a foreign asset in based currency is nothing other than the return of a leveraged portfolio, i.e. a portfolio invested 100% in the foreign asset and 100% in the assets currency. Total risk exposure is 200%; currency risk doubles the risk exposure.

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Note that the approximation works if rA, USD rS is small, which is the case when both currency spot and asset return are small. This is the case in normal markets only, not in turbulent times. As many calculations in spreadsheets and commercial performance and risk systems are based on this approximation, we end up with the paradoxical situation that approximate analytics fail when we need them the most. The notation and illustration developed above can now be used to derive the formulas for hedged returns. We will analyze three different types of hedge implementations. In all of them, we assume that the goal is to fully hedge currency risk. The results can be easily extended to partially hedged assets, with is simply a portfolio consisting of the unhedged and fully hedged assets, with the weight of the fully hedged being the hedge ratio.

Case I: The Perfect Hedge

The perfect hedge is a situation which we define as follows: We eliminate uncertainty about the future spot rate (and therefore currency risk) by entering into a currency forward contract at the beginning of the investment period. A currency forward contract is an agreement to exchange a certain amount in a certain currency into a certain different currency at a certain exchange rate. This contractually agreed exchange rate is the forward rate F1. The perfect hedge can be illustrated as follows
t0 X1, USD = X0, USD (1 + rA, USD) USD X0, USD X1, USD t1

X0, CHF / S0, USD/CHF

X1, USD F1

CHF

X0, CHF

X1, CHF

The only change to the unhedged situation is that F1 replaces S1. The formula for the perfectly hedged foreign asset in base currency RA, CHF is 1 + RA, CHF = ( X0, CHF / S0 ) (1 + rA, USD) F1 / X0, CHF = (1 + rA, USD) F1 / S0

The expression F1 / S0 - 1 is called the forward premium or forward discount rF, depending on whether the forward rate is above or below the current spot rate 1 + RA, CHF = (1 + rA, USD) (1 + rF)

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As before, the above expression can be approximated RA, CHF rA, USD + rF

Note that in the above calculations, we assume that we can exchange the amount X1, USD at the rate F1 agreed in t0. This is unrealistic: X1, USD is only known in t1 due to uncertainty about the assets gains and losses during the investment period. The amount to be exchanged in forward rate agreements, on the other hand, has to be specified in t0 already. The perfect hedge therefore implies perfect foresight regarding the future asset value. The forward exchange rate cannot be set at arbitrary values, as this would create arbitrage opportunities. The forward rate is determined by what is known as the covered interest rate parity, which states that the forward rate must equal the spot rate multiplied by the relative ratio of foreign and domestic riskfree rates rCHF and rUSD

F1 = S0 (1 + rA, CHF) / (1 + rA, USD)

Therefore, the forward premium is

rF = F1 / S0 = (1 + rCHF) / (1 + rUSD)

The exact formula for the return of the perfectly hedged foreign asset is

1 + RA, CHF = (1 + rA, USD) (1 + rCHF) / (1 + rUSD)

And the approximation formula becomes RA, CHF rA, USD + rCHF rUSD This can be read as follows: the return of the perfectly hedged foreign asset equals its return in local currency plus the difference in riskfree rates between the base currency and asset currency. Note that currency hedging completely removes the uncertainty regarding the future spot exchange rate (it can be shown that the volatility of the perfectly hedged foreign asset in base currency equals its volatility in asset currency). The perfect hedge does not result in the investor earning the local return of foreign assets; he earns the local return plus an interest rate differential. Generally speaking, the local return of foreign assets is not an investable asset; investable are only hedged, partially hedged or unhedged returns. The contribution of a foreign asset in an international portfolio cannot be altered without changing the contribution of the interest rate differential. These are
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the reasons why performance attribution models based on the Karnovsky/Singer approach have not become popular among practitioners: attribution effects need to be independent and tied to investable assets (we will elaborate on this point in a future research note).

Case II: Real-World Hedging

As we have discussed, perfect hedging is only feasible if the ending market value of risk assets is known. This is generally not the case in real-world portfolios. Real-world hedging is typically performed by hedging the beginning market value. Depending on whether the asset loses or gains in value, the asset will be over- or under-hedged. Graphically, this case can be illustrated as follows

t0 X1, USD = X0, USD (1 + rA, USD) USD X0, USD

t1 X1, USD

X0, CHF / S0, USD/CHF

X0, USD F1 + X0, USD rA, USD S1

CHF

X0, CHF

X1, CHF

The exact and approximate formulas are derived as follows X1,CHF = X0,CHF (1 + rCHF) / (1 + rUSD) + ( X0,CHF / S0 ) rA,USD S1 1 + RA, CHF = (1 + rCHF) / (1 + rUSD) + (1 + rS) rA, USD

RA, CHF rA, USD (1 + rS) + rCHF rUSD

We can now approximate the approximation

RA, CHF rA, USD + rCHF rUSD

We can see that in a second order approximation, the real-world result is equal to the perfect hedge. Note that this result is only valid in the case of small interest rate differentials and small currency and local asset returns. We can expect the second order approximation to be less accurate that the perfect hedge approximation.

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Case III: Realistic Money Market Hedging

The uncovered interest rate parity also tells us that a forward contract can be interpreted as a derivative instrument. Its total return can be statically replicated with a long position in the domestic riskfree asset and a short position in the foreign riskfree asset. As riskfree rates are hypothetical constructs that do not exist on real-world financial markets, one can use money market instruments as proxies. Such a strategy would involve buying the foreign asset plus a long position in a domestic money market instrument and a short position in a money market instrument in the asset currency. We can illustrate this situation as follows
X1, USD = X0, USD (1 + rA, USD) - X0, USD (1 + rUSD) + X0, USD S1 (1 + rCHF)

t0 USD X0, USD

t1 X1, USD

X0, CHF / S0

X1, USD S1

CHF

X0, CHF

X1, CHF

Note that we assume realistic money market hedging, i.e. we assume that we only hedge beginning market values. The exact and approximation formulas can be derived as follows

X1,CHF = (X0,CHF /S0 )(1+rA, USD)S1-( X0,CHF / S0 )(1+rUSD)S1+X0,CHF (1+rCHF) 1 + RA, CHF = (1 + rS) (1+rA, USD)- (1 + rS) (1+rUSD) +(1+rCHF)

RA, CHF rS + rA, USD - rS - rUSD + rCHF rA, USD + rCHF rUSD

The first order approximation of money market hedging is equal to the first order approximation of a perfect hedge and the second order approximation of a real-world hedge.

Numerical Examples
Let us feed the formulas derived above with some figures S0 = 1.45 X0,CHF = 100
rUSD = 1.5%

S1 = 1.435
rA, USD = 5.5% rCHF = 2%

F1 = 1.4571
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Based on these values, we can compare exact result and first and second order various approximations for the asset return NORMAL MARKETS Exact Unhedged Perfect Hedge Real-World Hedge Money Market Hedge 4.4086% 6.0197% 5.9357% 5.9586% Approximation I 4.4655% 6.0000% 5.9431% 6.0000% Approximation II 4.4655% 6.0000% 6.0000% 6.0000%

The range of the various possible calculations is 8.4bp for a parameter constellation typical for normal market conditions. In order to see what happens in turbulent market conditions, let us set S1 = 1.25 and rA, USD = 5.5%... TURBULENT MARKETS Exact Unhedged Perfect Hedge Real-World Hedge Money Market Hedge -21.9828% -9.0542% -7.6970% -7.4828% Approximation I -23.2931% -9.0000% -7.6897% -9.0000% Approximation II -23.2931% -9.0000% -9.0000% -9.0000%

The range of the various possible calculations is now 157.1bp

Conclusions
There are several correct formulas to calculate hedged returns, reflecting various ways of implementing a currency hedge. When taking into account approximations, the number of available formulas explodes, as various degrees of approximations can be performed. Certain correct formulas are based on unrealistic assumptions and cannot be implemented in real-world portfolios. Such formulas should not be used in calculating benchmarks for performance analysis purposes. When implementing hedged return formulas, further realistic features should be considered, like variable hedge horizon and costs.

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