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Currency Overlay: A Practical Guide - Second Edition

Description:
This fully updated and revised second edition of the best selling practical guide Currency Overlay continues to emphasise the same approach as in the First Edition: measuring currency risk separately in the portfolio, clarifying risk responsibility, using specialists where necessary, and taking control of the currency risk.

The underlying message remains unchanged: the future currency moves are hard to predict, it is easy by comparison to get reasonably well prepared. This new edition is full of practical hints and tips on how to get prepared in terms of currency risk management.

The much-elevated volatility level of the foreign exchange spot prices and a near-seizure of the foreign exchange forward and swap market at the height of the global financial crisis seem a distant memory for some, but many investors may be feeling distinctly uneasy about the currency risk in their global investment portfolios. In 2010, within a matter of a few months, we saw a euro scare, immediately followed by a US dollar scare. And, not quite on the fringe of the global currency market, there were ominous talks about “currency wars”. Looking ahead, many investors may be pondering on not only “known unknowns” but also, increasingly, “unknown unknowns” - “interesting times”, Confucius would have wisecracked.

The Second Edition of Currency Overlay: A Practical Guide does not attempt to disentangle the dense web of political, economic and sentimental factors that may drive the future moves of world’s currencies. Instead, it continues to emphasise the same approach as in the First Edition: measuring currency risk separately in the portfolio, clarifying risk responsibility, using specialists where necessary, and taking control of the currency risk. The underlying message remains unchanged: the future currency moves are hard to predict, it is easy by comparison to get reasonably well prepared. This new edition is full of practical hints and tips on how to get prepared in terms of currency risk management.

In the fully updated and expanded Second Edition, you will find:

- An overview of the overlay industry: managers, users, counterparties, custodians, and consultants
- Detailed discussions on the practical choices an investor would have to make on the currency management programme and their implications
- An up-to-date overview on the models and trading strategies researched on and used by practitioners and their performances drivers
- How to deal with emerging market currencies
- The reasons behind the increasing use of currency beta indices and the practical relevance of so-called currency alpha-beta separation
- A practical framework for setting a long-term benchmark hedge ratio

Currency Overlay: A Practical Guide (First Edition) was commended for its systematic approach to the subject, its neutral stance and clear structure, its rigorous yet accessible treatment of theories and academic research on the subject, and, above all, its practical how-to tips. The Second Edition retains all these features and is further enhanced by many useful insights and practical solutions. For investors revisiting their currency management policies and practices (or drafting one for the first time), the advice contained in this book is invaluable.

Testimonials
“Hai Xin and Risk Books continue to rigorously address key concerns and opportunities that currency exposure to international investing offers when institutional investors go global. Whether you want to risk manage or seek alpha returns in your global portfolio, this well researched practical guide to currency overlay is a must read for CIOs and their teams.”

Michael D. Huttman, Chairman of Millennium Global Investments Ltd

“With this Second Edition , Hai Xin makes again a very strong case for why global investors should look at the currency component of their portfolios separately. An essential reference book for anyone who needs to understand the nuts and bolts of currency management, to reduce an unwanted risk and turn it into new opportunities.”

Helie d’Hautefort, CEO of Overlay Asset Management

“Dr Hai Xin’s Second Edition of a practical guide to currency overlay contains well-researched solutions to many questions faced by investors as they constantly grapple with ever increasing and complex issues relating to the management of currency risks inherent in their international investments. Comprehensive and prudent currency risk management is essential to protect and enhance capital in any international portfolio. The solutions given in his book are practical, comprehensive, and balanced. Highly recommended.”

Felix Stephen, Manager Investment Strategy & Research - Advance Investment Solutions ( A member of the BT Financial Group) Sydney, Australia.
 
Contents:
1 Introduction
1.1 A brief history of the modern currencies
1.2 Some stylised facts about the foreign exchange market
1.3 Defining currency returns
1.4 A simple descriptive tour of currency risks
1.5 What is special about currencies?
1.6 FX risk management and currency overlay
Appendix 1a: Uncovered interest rate arbitrage
Appendix 1b: The correlation triangle
Appendix 1c: Forecast, forward and no-arbitrage price

2 Currency Overlay Management
2.1 Introduction
2.2 Origins and development of currency overlay
2.3 Different approaches to managing currency risks
2.4 Definitions and merits of currency overlay
2.5 What an overlay process looks like in practice
2.6 Trading styles for active overlay and currency pure alpha
2.7 Overview on the main parties involved in currency business
2.8 Historical performance of currency overlay programmes
2.9 Outsourcing currency management
2.10 Summary
Appendix 2a: Main players in the currency overlay market

3 Currency Overlay: Some Practical Choices
3.1 Introduction
3.2 Choices for overall currency management policy
3.3 Choices for passive overlay
3.4 Choices for active overlay
3.5 Choices for pure alpha
3.6 Overlay and prime brokerage
4 FX Research and Choice of Currency Management Styles
4.1 Introduction
4.2 Purchasing power parity (ppp) based models
4.3 Back to fundamentals: macroeconomic models of foreign exchange determination
4.4 Technical analysis
4.5 Two warhorses: carry and trend
4.6 Other types of quantitative forecast models
4.7 Currency beta indices
4.8 Putting research into action
4.9 Summary: relevance of forecast models in a portfolio management context
Appendix 4a: Central bank intervention
Appendix 4b: Foreign exchange and cross-border merger and acquisition announcements

5 Optimisation and Hedge Ratio
5.1 Introduction
5.2 CAPM and currencies
5.3 CAPM, foreign exchange hedging and overlay
5.4 Global optimization and the role of currency
5.5 Hedge ratios
5.6 Asset–liability optimization
5.7 Currency basket hedging
5.8 Sector-based investment and currency management

6 Benchmark Design and Performance Measurement
6.1 Introduction
6.2 Setting a good benchmark
6.3 Customized benchmarks: risk separation and risk responsibility
6.4 Dissecting currency returns
6.5 The currency surprise approach
6.6 The excess return approach
6.7 Holding-based benchmarks
6.8 Adjustment style
6.9 Other practical considerations

7 Overlay and Alpha Beta Separation
7.1 Introduction
7.2 Alpha and beta for currencies
7.3 The rationale behind passive overlay plus pure alpha
7.4 The best implementation methods and other considerations

8 Options, Dynamic Hedging and Overlay
8.1 Introduction
8.2 Option pricing theory and dynamic hedging
8.3 Skews and smiles
8.4 Trading opportunities in the options market
8.5 Speaking Greek – some closing comments

9 Emerging Market Currencies
9.1 Background
9.2 The hedging debate in EM currencies
9.3 Carry, trend and value in EM currencies
9.4 Use options to trade EM currencies
9.5 Other related issues
9.6 Summary

10 Liquidity, Counterparty Risk and E Commerce
10.1 Introduction
10.2 Foreign exchange liquidity: theory and reality
10.3 Counterparty credit risk
10.4 E-commerce

11 Conclusions
11.1 Summary of the main arguments
11.2 A practical framework of setting benchmark hedge ratios
11.3 A currency overlay checklist
 
Author
Hai Xin

Hai Xin is based in Hong Kong, a managing director and head of Asia Pacific of Overlay Asset Management (OAM), one of BNP Paribas Investment Partners. He joined the firm in 2005, focusing on business development of currency overlay and currency pure alpha services in the region. Before that, Hai Xin worked for the investment bank of UBS (previously Swissbank Corporation, SBC Warburg, SBC Warburg Dillon Read, Warburg Dillon Read, and UBS Warburg – a succession of names, a small footnote to the consolidation of the banking sector) in a variety of positions: financial engineer within Foreign Exchange Division; “permanent insider” within Corporate Finance Division advising currency risk management in cross-border merger and acquisition transactions; originator within Equity Capital Market Group dealing with Hong Kong or overseas IPOs and equity block trades by Chinese companies. Prior to joining UBS he worked as a researcher at AstraZeneca Treasury and a relief producer for current affair programmes at BBC World Service. Before coming to Hong Kong, Hai also started a tofu factory based in the UK.

Hai obtained his PhD in quantitative finance from Imperial College, London, and MSc in economics from the London School of Economics, both part of the University of London. His bachelor’s degree is in electronics and information science, from University of Science and Technology of China. Hai has been a visiting scholar at Hong Kong University of Science and Technology since 2010, lecturing on statistics as well as investment banking.

Hai has published three books aiming at general public in Chinese: one being a general introduction to finance and investment, the other two about quantitative investment and high-frequency trading.
 
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