As more asset owners adopt centralised currency management strategies, the need to assess the effectiveness of currency overlay decisions has become increasingly important. A well-constructed currency attribution framework enables firms to quantify the value these decisions bring to a fund’s overall return.
Ortec Finance, a global provider of technology and solutions for risk and return management, recently offered guiddance on how to develop an effective currency attribution framework.
Currency attribution differs significantly from standard market investment decision-based attribution due to the distinct nature of currencies, which are often partially hedged. To address this, attribution models must include customised benchmarks that accurately reflect specific currency decisions, offering a tailored lens into performance assessment, it said.
Central to any currency overlay framework is the benchmark design. These benchmarks should reflect an asset owner’s unique approach to foreign exchange exposure—ranging from full hedging to selective exposure. Whether targeting major currencies only or replicating a strategic asset allocation (SAA) model, the benchmark must align with the fund’s hedging philosophy. It typically involves setting currency hedging percentages relative to either the fund’s currency exposure benchmark or total fund value. Measuring returns for each currency can be done via virtual hedge returns, which simulate daily-rolled three-month forward contracts.
Once the strategic hedging levels are defined, currency overlay managers move into execution. This phase may involve substituting illiquid currencies, adjusting rebalancing frequencies, or tactically deviating from the strategic exposure based on short-term forecasts. To accurately assess value, each step in the currency overlay process should be benchmarked separately. These “adjusted” benchmarks highlight the contribution of each tactical and operational choice.
Beyond allocation, implementation plays a vital role in determining value added. This final decision layer assesses actual hedge returns versus the virtual hedge returns used earlier in the process. Here, returns diverge due to real-world factors like contract maturities and instruments used, providing insight into the effectiveness of execution.
The final layer of analysis integrates currency overlay attribution with market decision-based attribution.
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