academy #6 interest rates, currencies & hedging

Academy #6Interest rates, currencies & hedging

Get connected to B&R Beurs @1

“Europe’s Central Banks Diverge on Path” -The Wall Street Journal

„For the first time in a long time, you don‘t have to be an optimist to see the glass as half full.“ –Mark Carney Bank of England

„Employing unusually sharp language, the U.S. on Wednesday openly criticized Germany's economic policies and blamed the euro-zone powerhouse for dragging down its neighbors and the rest of the global economy.” -WSJ

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Current News

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Current News

4

Current News

5

Current News

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Current News

2011

Q1

2011

Q2

2011

Q3

2011

Q4

2012

Q1

2012

Q2

2012

Q3

2012

Q4

2013

Q1

2013

Q20

200,000400,000600,000800,000

1,000,0001,200,0001,400,000

Wealth in the EU

GermanyNetherlandsBelgium

Net

Wea

lth

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Current News

2011Q1 2011Q2 2011Q3 2011Q4 2012Q1 2012Q2 2012Q3 2012Q4 2013Q1 2013Q2

-1,500,000

-1,000,000

-500,000

0

500,000

1,000,000

1,500,000

Wealth in the EU

GermanyNetherlandsBelgiumSpainItalienPortugalGreeceN

et W

ealth

Definition:

“Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.”

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Hedging

Definition:

“Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.”

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Hedging

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Hedging Example:

◦ We think Adidas will do better than the market

◦ But we do not want to bet on the overall market

◦ What can we do?

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Hedging Let’s look at data:

1/3/20

12

1/26/2

012

2/18/2

012

3/12/2

012

4/4/20

12

4/27/2

012

5/20/2

012

6/12/2

012

7/5/20

12

7/28/2

012

8/20/2

012

9/12/2

012

10/5/2

012

10/28

/2012

11/20

/2012

12/13

/2012

1/5/20

13

1/28/2

013

2/20/2

013

3/15/2

013

4/7/20

13

4/30/2

013

5/23/2

013

6/15/2

013

7/8/20

13

7/31/2

013

8/23/2

013

9/15/2

013

10/8/2

013

10/31

/2013

020406080

100120140160180

ADIDASDAX

Let’s look at even more data:

What can we do?

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Hedging

-0.04 -0.03 -0.02 -0.01 0 0.01 0.02 0.03 0.04 0.05

-0.06

-0.04

-0.02

0

0.02

0.04

0.06

0.08

0.1

f(x) = 0.908655860332166 x + 0.000382277701492846R² = 0.430294183237306

Hedging

ReturnsLinear (Returns)

Dax Return

Addi

das

Reut

rn

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Hedging Hedged position in Adidas:

1/3/20

12

2/22/2

012

4/12/2

012

6/1/20

12

7/21/2

012

9/9/20

12

10/29

/2012

12/18

/2012

2/6/20

13

3/28/2

013

5/17/2

013

7/6/20

13

8/25/2

013

10/14

/2013

020406080

100120140160180

ADIDASDAXHedged

DAX ADIDAS HedgedReturn 0,000896 0,001196 0,000383σ 0,010663 0,014771 0,011161Sharpe 0,083981 0,080969 0,034288

Currency risk: additional volatility after transforming returns of a foreign investment in our domestic currency compared to returns measured in local currency

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Foreign currencies as a risk factor

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Foreign currencies as a risk factor

Volatility in EUR: σDAX,EUR = 23.83% Volatility in CHF: σDAX,CHF = 26.26% Currency Risk : σDAX,EUR - σDAX,CHF = 2.43%

02 03 04 05 06 07 08 09 10 11 1240%

60%

80%

100%

120%

140%

160%

180%

DAX in € Dax in CHFSource: datastream

Currency risk is not the volatility of the FX-rate!

In previous case: σCHF,EUR = 7.22% Why is currency risk lower?

Imperfect correlation between DAX returns in EUR and CHF/EUR FX-returns (0.2)

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What is currency risk?

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Currency risk differs among asset classes & currencies (1)

Citigroup WGBI US BIG Barclays UK Gov. Bonds Long

3.7%

8.2%

10.5%

13.8%

in local currency in EUR

Large increase of volatility for bondsSource: datastream, bloomberg1999 -2012

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Smaller (proportional) increase in volatility Large currency risk for Australian Dollar

Currency risk differs among asset classes & currencies (2)

S&P 500 FTSE 100 MSCI Australia

16.3%15.0%

13.3%

16.5%

19.1% 19.0%

in local currency in EURSource: datastream, bloomberg, yahoo1999-2012

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Commodities: for EUR-investor negative! Hedge Funds: high currency risk

Currency risk differs among asset classes & currencies (3)

DJ UBS Commodity Index HFRX Global Hedge Fund Index

17.6%

6.4%

15.5%

10.6%

in local currency in EURSource: bloomberg1999-2012

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Currency risk differs among currencies Safe haven currencies (e.g. USD & JPY) tend

to appreciate when int. stock markets fall May provide a natural hedge

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Currency risk differs among currencies AUD & CAD tend to depreciate when int.

stock markets fall (pos. correlated) mostly better off hedging them

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Two approaches in practice1. Hedging according to asset classes:

practitioners‘ approach: hedging foreign bonds but not foreign stocks

easy to implement, but neglects correlations2. Currency Overlay:

Currencies are hedged regarding their correlation with the total portfolio

requires permanent analysis

Currency hedging in a portfolio

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Currency hedging in a portfolio

Stock A (EUR) Bond B (EUR)

Stock A (EUR) 1 σA,B

Bond B (EUR) 1

Assume a portfolio with two domestic assets

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Currency hedging in a portfolio

…and now one with two foreign assetsStock A

(USD)Bond B

(JPY)FX

EUR/USDFX

EUR/JPYStock A (USD) 1 σA,B σA,USD σA,JPY

Bond B (JPY) 1 σB,USD σB,JPY

FX EUR/USD 1 σUSD,JPY

FX EUR/JPY) 1

Hedging according to asset classes ignores 3 out of 6 correlations!

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To hedge or not to hedge? Investing in global stocks as an European

investor

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bonds pay interest periodically and provide a predictable income stream

to diversify risk

to preserve the capital investment

Why invest in bonds?

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Bonds ≠ Stocks Limited upside potential

You get the coupon and principal

In case of default Large part of the investment

is lost

Unknown upside potential You can benefit from this

Unknown downside potential Usually lower than in case of a

bond default

Special attention to ratings when buying a bond

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Credit risk: How likely is that the issuer will actually repay?

Term: How far in the future are the payments?◦ Strongly related to inflation risk and changes in

the key interest rates!

Seniority: What is my payment priority when the company actually defaults or goes out of business

What determines the bonds characteristics?

„Interest rate that sets the current price of the bond equal to all the future cash flows“

So it is the solution to the following eqution:

It is a standardized way to compare prices

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Yield

Interest rate risk: - captures the effect of changes in the market rate of interest on investment value- affects more the value of bonds- when interest rate rises, bond value (price) falls

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Interest rate risk

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Term Structure

USGG2YR INDEX USGG5YR INDEX USGG10YR INDEX0

0.5

1

1.5

2

2.5

3

Yields 13.11.2013

Yields 13.11.2013

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Term Structure

1/2/20

12

3/6/20

12

5/9/20

12

7/12/2

012

9/14/2

012

11/17

/2012

1/20/2

013

3/25/2

013

5/28/2

013

7/31/2

013

10/3/2

013

0

0.5

1

1.5

2

2.5

3

3.5

USGG10YR INDEXUSGG5YR INDEXUSGG2YR INDEX

Term structure is not constant

Interest rate risk is approximated by duration (the % change in the security price for a 1% change in yield)

Duration can also be seen as the average time until you get the payments

For a zero-coupon bond: duration = maturity

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Interest rate risk - Bonds (1)

A bond with higher duration is perceived as more risky

Lower coupon -> higher duration

Longer maturity -> higher duration

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Interest rate risk – Bond (2)

Any Questions?

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Hedging Hedged position in Adidas:

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