The core idea behind hedging is that it removes the risk of adverse exchange rate movements on a portfolio's returns.
In most cases, hedging is carried out by purchasing instruments that have equal but opposite exposures to the assets held in each currency. If exchange rates then drive down the values of assets in one currency, the value of the hedge will increase by a similar amount, so that overall the change in FX rates will leave the portfolio's returns unchanged. Suitable hedging instruments are forwards, cash or options.
While it is possible, in principle, to rebalance a portfolio's hedges each day, in practice this would be prohibitively time-consuming, so many fund managers typically purchase forwards hedges with a lifetime of several months, and accept any gains or losses made by market fluctuations over that period as part of their management costs.
The theoretically hedged return of a portfolio is calculated by assuming that its FX exposures are always perfectly hedged. FIA calcualates this quantity by setting the theoretically hedged return of each security to its local currency return, plus a cost of hedging. The cost of hedging can be positive or negative, and is calculated as the interest rate differential between the portfolio's base currency and the currency of exposure, times the elapsed time.
To display theoretically hedged returns in FIA, follow these steps:
- Set the HedgeReturns switch to true in the configuration file
- Select a base currency for hedging by setting the HedgeCurrency setting in the configuration file to the code of the currency
- For each currency represented in your portfolio, set up a security in the master file that has its ID as the currency code. Then enter the name of a yield curve in the 'curve' field for that security. This is the yield curve that will supply the interest rates used in hedging calculations. The curve can refer to an existing field, or another curve that has been set up purely for hedging purposes.
- If a new curve has been referenced in the security master file, ensure that a corresponding curve has been set in the yield curve file.