Asset Management. Overlay Management. Markus Kramer, CFA, CMT, FRM August PDF Free Download

Overlay Management Markus Kramer, CFA, CMT, FRM August 2014

Content 1 2 3 4 The Case for Overlay Management Interest Rate Overlay How to Hedge Against Inflation Currency Overlay How to Protect Returns in Foreign Bonds and Equities Credit Overlay How to Weather the Next Credit Crisis 5 Appendix August 2014 2

1 The Case for Overlay Management An Example Currency risk Credit risk Interest rate risk August 2014 3

1 Financial Markets Interest Rates 2.50 2.00 1.50 Rates Volatility Index (MOVE) Rates USD (10y) Rates EUR (10y) Rates CHF (10y) Rates JPY (10y) 1.00 0.50 0.00 Jan 04 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12 Jan 13 Jan 14 What happens after the secular downtrend of interest rates ( Great Moderation )? How to protect against inflation risk All time series are indexed (01.01.2004 = 1). Sources: Bloomberg, Credit Suisse August 2014 4

1 Financial Markets Currencies 3.00 2.50 Currency Volatility Index (CVIX) Trade Weighted CHF USDCHF 2.00 EURCHF 1.50 1.00 0.50 Jan 04 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12 Jan 13 Jan 14 How do Swiss investors deal with a structurally strong currency such as the Swiss franc? How can they smooth the contribution of currency volatility to a foreign bond or equity portfolio? All time series are indexed (01.01.2004 = 1). Sources: Bloomberg, Credit Suisse August 2014 5

1 Financial Markets Credit 16.00 14.00 12.00 Volatility (ITRAXX Main, 30d historical volatility) Credit Index Europe (ITRAXX Main) Credit Index Emerging Markets (CDX EMMA) 10.00 8.00 6.00 4.00 2.00 0.00 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12 Jan 13 Jan 14 How to profit from credit risk premiums without facing periodical drawdowns All time series are indexed (01.01.2004 = 1). Historical performance indications and financial market scenarios are not reliable indicators of current or future performance. Sources: Bloomberg, Credit Suisse August 2014 6

1 One Possible Investment Scenario Stall speed economy Global economy continues to be unbalanced, policy uncertainty is a constraint on growth and the fragile state of the recovery leaves activity vulnerable to even modest negative shocks Monetary reflation Not one major central bank is in tightening mode, which is less a tool to stimulate growth but rather a measure to maintain financial stability and reduce tail risks (e.g. the European Central Bank s commitment to do whatever it takes ) as well as to support asset prices Currency: full hedge USD versus CHF Interest rate: extension of duration Credit risk: buying corporate bonds instead of government bonds Search for yield As riskless assets become rarer (being bought by central banks), fixed income investors move from government bonds into credit markets (credit spread) or extend the duration of their portfolios (term spread) Historical performance indications and financial market scenarios are not reliable indicators of current or future performance. August 2014 7

1 Unbundling of Financial Instruments 1. Supply 2. Dissection of risks 3. Overlay management Credit Credit Credit Currency Currency Currency Duration Duration Duration Why derivatives? Liquidity: considerable volumes tradable without price impact Lower transaction costs: low bid ask spreads, no exchange fees, brokerage fees, taxes Flexibility: each risk/return dimension can be managed separately, opportunity for short positions, leverage August 2014 8

2 Hedging of Interest Rate Risks Lower interest rate risks but Transaction costs Negative carry: the yield of the hedged portfolio is the lower the steeper the interest rate curve Decision Expected interest rate versus breakeven rate increase (the breakeven rate increase is the move of the interest curve for which the following condition holds: reduced loss thanks to hedge = hedging cost) Implementation Absolute versus relative duration target Active versus passive implementation Tolerance limits Breakeven interest rate increase For illustrative purposes only. Source: Credit Suisse August 2014 10

2 Implementation Absolute duration target Passive implementation The client specifies an absolute duration target (e.g. 3 years) A duration change of a reference bond portfolio does affect the overlay The portfolio manager implements the client s duration target within tight bandwidths, for instance +/-0.2 years (trade-off between hedging precision and minimization of transaction costs) Relative duration target Active implementation The client specifies a duration target relative to its bond portfolio (e.g. -3 years) A duration change of a reference bond portfolio does not affect the overlay The portfolio manager chooses the duration within broader bandwidths (for instance +/-1 year versus client s duration target) according to Credit Suisse s interest rate forecasts Historical performance indications and financial market scenarios are not reliable indicators of current or future performance. Sources: BofAML, Bloomberg, Credit Suisse Last data point: As of 01.07.2014 August 2014 11

2 Hedging Instruments Interest rate futures Highly liquid and standardized contracts Best known are probably Treasury Futures (USD interest rates) or Bund Futures (EUR interest rates) Interest rate swaps Hedging of real rates and inflation Receiving short-term interest rate e.g. three or six month Libor (floating leg) Paying long-term interest rate e.g. 10-year swap rate (fixed leg) Inflation swaps Hedging of inflation Receiving realized inflation (floating leg) Paying expected inflation (fixed leg) August 2014 12

2 Hedging Instruments Treasury Future Sources: Bloomberg, Credit Suisse August 2014 13

3 Currency Overlay Approaches Risk reduction Return enhancement Client with a globally diversified portfolio: need for protection of underlying returns and volatility reduction Client with considerable liquidity: searching for investment alternatives to cash accounts Competitive devaluation ( currency wars ): divergence of hedged and unhedged market returns Currency overlay with strategic hedge ratios: e.g. 50% for equities and 80% for bonds Scarcity of investment opportunities: low yield environment Currency overlay with tactical hedge ratios: e.g. +/-25% August 2014 15

3 Currency Overlay Overview Client Investment accounting Which portfolios and positions? Which currencies, hedge ratios and bandwidths? Approach: risk reduction or return enhancement? Internal and external positions incl. currency splits Currency forwards Market and benchmark data Reporting Performance reporting Position reporting Roll reporting Performance attribution Special analysis Daily calculation and control of hedge ratios Order management system CRIMS Overlay Management Tenor management Liquidity management Risk management Execution Daily control of compliance with guidelines Control of all transactions (pre trade and post trade) Execution desk (Credit Suisse, external broker) Execution 360T Execution prime broker Source: Credit Suisse August 2014 16

3 Some Thoughts on Currency Hedging Empirical analysis shows that the optimal hedge ratios vary depending on the underlying (stocks, bonds, real estate), the time period and the currencies involved. Currencies involved Currency hedging eliminates foreign currency risk, but it results in greater exposure to the domestic currency and interest rate markets. Hedging a high beta foreign currency position and increasing exposure to a safe haven domestic market (such as the Swiss franc) tends to reduce overall volatility, as movements in global risk assets offset the counter-cyclical fluctuations of the defensive currency. However, an investor whose base country is tightly linked to global growth momentum (such as the Canadian dollar or the Australian dollar) and who hedges exposure to a defensive market is, in fact, transferring risk instead of reducing it. Underlying The risk contribution of currencies to the underlying portfolio varies over the asset classes. It is empirically measured that currencies add little volatility to a global equity portfolio, while they have a significant influence on the risk of a global bonds portfolio. Time period Depending on the currency trends and the yield differentials, the optimal hedge ratio can change over time. While it was profitable for a CHF based investor to hedge a USD bonds portfolio between 2008 and 2012 (because of the massive expansive monetary policy of the Fed), it would have been optimal to hedge the same portfolio only by 50% or less between 2004 and 2007 due to an environment of a sideways trading USD/CHF. August 2014 17

3 Varying Optimal Hedge Ratios USD bonds (GBI US) 2004 2007 USD equities (S&P 500) 2004 2007 USD bonds (GBI US) 2008 2012 USD equities (S&P 500) 2008 2012 Historical performance indications and financial market scenarios are not reliable indicators of current or future performance. Source: Credit Suisse As of October 2012 August 2014 18

3 Hedging Instruments Currency forwards A non-standardized contract between two parties to buy or to sell an asset at a specified future time at a price agreed upon today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. Example: sell USD 100,000 versus CHF per 12.03.2014 at 0.886593 (mid rate, see following slide) Currency futures A contract to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date. Typically, one of the currencies is the USD. The trade unit of each contract is then a certain amount of another currency, for instance EUR 125,000. Most contracts have physical delivery; so for those held at the end of the last trading day, actual payments are made in each currency. However, most contracts are closed out before that. Currency options A derivative financial instrument that gives the owner the right but, not the obligation, to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date August 2014 19

3 Hedging Instruments Currency Forward USD/EUR Sources: Bloomberg, Credit Suisse August 2014 20

3 Where We Are Searching for Opportunities (1/2) Although currency markets are highly liquid they are not always efficient, as momentum effects or excessive volatility show. One reason is the existence of market participants (e.g. central banks, multinational corporations, tourists) that are not primarily profit seeking (as is mostly the case with market participants in bonds or equity markets). Momentum: Currencies show trending behavior over time, which suggests that using past prices may be informative for investing in currencies. One reason for momentum is that market participants not only use fundamental data (exogenous information) but also market prices (endogenous information) to assess currencies. With the help of technical analysis as well as a quantitative model, the Global Currency Group (GCG) tries to identify the prevailing market phase (trending versus non-trending market) as well as the appropriate indicators (e.g. trend indicators such as Elliot waves or moving averages versus oscillators and patterns) Carry: According to the uncovered interest rate parity, carry trades should not yield a predictable profit because the difference in interest rates between two countries should equal the rate at which investors expect the low interest rate currency to rise against the high interest rate one. In practice, however, there are currencies that do not appreciate/depreciate as much as they should according to yield differentials. Based on fundamental analysis as well as on a quantitative model, the GCG screens the main currencies for carry opportunities, which involves buying high interest rate currencies (e.g. AUD) and selling low interest currencies (e.g. USD) Source: Credit Suisse August 2014 21

3 Where We Are Searching for Opportunities (2/2) Differing valuation models: Typically, most investors share the same or similar information relevant for financial markets. However, they often do not agree on the valuation model and differ in the pricing of new information sometimes for an extended time period. The variety of pricing opinions tends to rise in crisis driven markets and complex instruments. The GCG uses a broadly based scoring approach that is based on various qualitative and quantitative sources (real and monetary economic analysis as well as sentiment, positioning, flows and technical analysis). By capturing, comparing and dynamically weighing the different signals from these sources, the GCG approximates the value of selected currencies. Portfolio diversification: Currency markets are often lowly or even negatively correlated with equity and fixed income markets The GCG uses currencies in its global fixed income portfolios and actively managed currency overlays in order to diversify the risk exposures with highly liquid instruments (most of the currency pairs offer considerably more market depth than other financial instruments) Source: Credit Suisse August 2014 22

4 Credit Overlay Approach Default risk (expected loss) Spread risk (Market to market risk) Risk of a loss due to a credit event in the meantime Default risk ~ default probability loss given default Risk of a changing market value due to a change in the expected probability of a credit event Hedging Hedging Nominal value of credit default swap should match the market value of the underlying Unsystematic (issuer specific) risk is relevant The credit spread sensitivity of the credit default swap should correspond to the sensitivity of the underlying The systematic (market or beta) risk is relevant We follow a two step approach: Estimation of the hedge ratio for an optimal hedge of the spread risk with an index credit default swap (e.g. ITRAXX or CDX) Eventual hedge of the residual default risk with single name credit default swap Source: Credit Suisse August 2014 24

4 Choosing the Appropriate Hedging Instruments Strong and stable correlation of underlying and hedging instrument (basis risk) Relative volatility if no leverage is allowed Liquidity of the various credit default instruments (index, single name) Issuer composition of underlying and credit default swap index (in order to estimate the residual jump to default risk) August 2014 25

4 Hedging Instruments ITRAXX Main Sources: Bloomberg, Credit Suisse August 2014 26

5 Credit Suisse Overlay Services Interest rate overlay Credit overlay Centralized management of duration on the level of total assets or several consolidated bond portfolios CHF 8bn Management of inflation by implementing an overlay strategy with inflation-linked swaps across several portfolios or in combination with inflation-linked bonds CHF 4.4bn Management of credit with an overlay strategy using credit default swap indices CHF 0.5bn Currency overlay Centralized management of currencies on the level of total assets with individual hedge ratios per currency; currently we manage the following overlays: CHF 12.8bn integrated currency overlay within global fixed income portfolios and funds with individual currency hedging including hedged tranches CHF 7.5bn segregated currency overlay mandates on the level of clients overall assets CHF 0.9bn currency hedging of third party funds ( share class hedging ) Total currency management of more than CHF 21.2bn August 2014 28

5 Overlay Team Daniele Paglia Daniele Paglia, Director, is a Senior Portfolio Manager. He heads the Overlay & Engineered Solutions team and is responsible for inflation-linked and derivative based products. Prior to joining Credit Suisse in 2002, he spent three years as a quantitative fixed income analyst and portfolio manager at Zurich Cantonal Bank. Before that he worked at UBS for six years, as a fixed income analyst in Zurich and as a debt market strategist in London. He graduated from the University of Zurich, specializing in Finance and Operations Research. Markus Kramer Markus Kramer, Vice President, is a Senior Portfolio Manager for Global Fixed Income portfolios and responsible for currency overlays. Prior to joining Credit Suisse in September 2011, he worked at Zurich Cantonal Bank for six years. He holds a master s degree from the University of Zurich (specializing in Banking and Finance) and is a Chartered Financial Analyst (CFA) as well as a Certified Financial Risk Manager (CFRM) and a Chartered Market Technician (CMT). Furthermore, Markus is a board member of the Swiss Bond Commission. Philipp Büchler Phillipp Büchler, Managing Director, is responsible for Global Fixed Income Institutional. He joined Credit Suisse in 2005 from the Swiss National Bank where he was a senior portfolio manager, responsible for USD Core and EUR Corporate portfolios. Prior to that, he worked as a consultant at Ecofin Investment Consulting. Previously, Philipp worked at UBS Brinson and Swiss Bank Corporation in New York and Geneva. He holds an MSc in Economics from the London School of Economics and an MSc in Economics and Political Science from the University of Berne, and is a CFA charterholder. Christoph Durst Christoph Durst, Vice President, is responsible for currency overlays for the exclusive and fund mandates as well as for the cash management on the exclusive side. Christoph joined Credit Suisse in June 2008. Prior to his role at Credit Suisse he was responsible for the foreign exchange, cash management and fixed income team at Basellandschaftliche Kantonalbank. Before that Christoph worked at UBS Investment Bank as a currency specialist dealing with asset managers and wealth managers. Christoph successfully qualified as Certified International Investment Analyst (CIIA) in 2011 and holds the ACI Diploma since 2006. August 2014 29

5 Currency Overlay Team Dr. Urs Haberthür Dr. Urs Haberthür, Vice President, is a Senior Portfolio Manager for rule based portfolios, and maintains and develops financial tools like performance attribution and risk management models for the fixed income investment process. He joined Credit Suisse in January 2005 after completing his PhD in Natural Sciences at the University of Zurich. Urs holds a master s degree in Physics from the Swiss Federal Institute of Technology in Zurich, and worked for the IT department at the University of Zurich during his PhD. Dr. Samuel Huber Dr. Samuel Huber works as a Junior Portfolio Manager in the Global Fixed Income team. He is also responsible for processing scientific surveys and developing quantitative tools, such as algorithmic trading strategies for currency management. Before joining Credit Suisse in 2010, he worked in the asset management of the pension fund at F. Hoffmann-La Roche AG in Basel for two years. Samuel studied Economics at the University of Basel and completed his PhD in the field of Economic Theory in 2013. Dr. Manuel Walker Dr. Manuel Walker, Vice President, is a Senior Portfolio Manager for credit and special portfolios (e.g. cash flow matching products) and maintains and develops financial tools like performance attribution and risk management models for the fixed income investment process. Before joining Credit Suisse in November 2005, he was postdoc student in Biochemistry at the University of Zurich. He holds a master s degree in Physics and a PhD in Theoretical Practical Physics from the University of Berne. In 2010 he graduated as a Certified Financial Risk Manager (CFRM certified by the Global Association of Risk Professionals). August 2014 30

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Asset Management. Overlay Management. Markus Kramer, CFA, CMT, FRM August 2014