CHAPTER 1 INTRODUCTION
1.1 A brief history of modern currencies 2
1.2 Some facts about the foreign exchange market 4
1.3 What is special about currencies? 7
1.4 Foreign exchange risk management and currency overlay 18
1.5 About this book 34
CHAPTER 2 A PRIMER ON CURRENCY RISK
2.1 Introduction 39
2.2 Defining and decomposing currency returns 40
2.3 A simple descriptive tour of currency risks 50
2.4 Choice of currency management styles 62
2.5 Risk separation and risk responsibility 69
Appendix 2A: Uncovered interest rate arbitrage 71
Appendix 2B: The correlation triangle 72
Appendix 2C: Forecast, forward and no-arbitrage price 74
Appendix 2D: Risk measures 75
Appendix 2E: Co-dependence 79
CHAPTER 3 CURRENCY OVERLAY MANAGEMENT
3.1 Introduction 85
3.2 Origins and development of currency overlay 86
3.3 Definitions of currency overlay 86
3.4 What an overlay process looks like in practice 90
3.5 Advantages of employing currency overlay 93
3.6 Trends and opportunities in currency overlay 95
3.7 Currency overlay managers – what do they do? 98
3.8 Historical performance 105
3.10 Trading styles 119
3.11 Overlay and prime brokerage 121
Appendix 3A: A typical overlay mandate 124
Appendix 3B: Currency overlay services – the big players 135
CHAPTER 4 FOREIGN EXCHANGE RESEARCH AND THE
CHOICE OF CURRENCY MANAGEMENT STYLE
4.1 Introduction 143
4.2 Purchasing power parity (PPP) based models 145
4.3 Back to fundamentals: macroeconomic models of foreign 149
exchange determination
4.4 Technical analysis 155
4.5 Quantitative models 158
4.6 Some other practicalities 185
4.7 Summary: Relevance of forecast models in a portfolio management context 188
Appendix 4A: Central bank intervention 189
Appendix 4B: Foreign exchange and cross-border merger and acquisition announcements 190
CHAPTER 5 OPTIMISATION AND HEDGE RATIOS
5.1 Introduction 197
5.2 CAPM and currencies 198
5.3 CAPM, foreign exchange hedging and overlay 204
5.4 Global optimisation and the role of currency 205
5.5 Hedge ratios 210
5.6 Asset–liability optimisation 221
5.7 Currency basket hedging 223
5.8 Sector-based investment and currency management 225
CHAPTER 6 BENCHMARK DESIGN AND PERFORMANCEMEASUREMENT
6.1 Introduction 229
6.2 Setting a good benchmark 230
6.3 Customised benchmarks: risk separation and risk responsibility 232
6.4 Dissecting currency returns 234
6.5 The currency surprise approach 235
6.6 The excess return approach 239
6.7 Holding-based benchmarks 241
6.8 Adjustment style 247
6.9 Other practical considerations 253
6.10 Performance-based benchmarks 263
CHAPTER 7 OPTION PRICING THEORY AND DYNAMIC HEDGING
7.1 Introduction 267
7.2 Option replication and dynamic hedging 268
7.3 Transaction costs and option replication 271
7.4 Portfolio insurance 272
7.5 The redundancy of options 275
7.6 Skews and smiles 278
7.7 Trading opportunities in the options market 281
7.8 Some volatility-based trading schemes 290
7.9 Speaking Greek – some closing comments 293
Appendix 7A: Using a forward volatility agreement to take a position on volatility 293
CHAPTER 8 EMERGING MARKET CURRENCIES
8.1 Background 297
8.2 Special characteristics of emerging market currencies 298
8.3 Forward bias and emerging market currencies 301
8.4 Implied volatility 304
8.5 Other related issues 308
8.6 Summary 312
Appendix 8A: Major emerging market currencies 312
Appendix 8B: Emerging market research – an example 314
CHAPTER 9 LIQUIDITY, ONLINE DEALING AND E-COMMERCE
9.1 Introduction 329
9.2 Foreign exchange liquidity: theory and reality 330
9.3 E-commerce 334
9.4 Custodian banks and eFX 345
Appendix 9A: Some service providers 347
CHAPTER 10 CONCLUSIONS AND AN OVERLAY CHECKLIST
10.1 Summary of the main arguments 353
10.2 A currency overlay checklist 356
Appendix A: Euro fixings 361
Appendix B: List of currencies 363
Bibliography 369
Index 387
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