How do you balance risk and return in currency diversification?

Finding the equilibrium between risk and return when it comes to currency diversification is a strategic dance. It involves carefully assessing various factors such as economic indicators, geopolitical events, and market sentiment. By diversifying across currencies, one aims to mitigate the risks associated with any single currency while seeking opportunities for returns. This entails thorough analysis, staying abreast of global developments, and employing hedging strategies where necessary. Ultimately, it's about striking a balance that aligns with one's risk tolerance and investment objectives.

Active vs. Passive: Active management requires constant monitoring and adjustments, potentially offering higher returns but with higher fees. Passive strategies like low-cost exchange-traded funds (ETFs) offer diversification benefits with lower fees but require less flexibility. Hedging Strategies: Using options or derivatives can partially offset potential losses from currency fluctuations. Consider regional trade partners: Diversifying into currencies of major regional trading partners can provide natural hedges against fluctuations based on trade flows. Develop a strong understanding of regional geopolitical dynamics: Political instability can significantly impact currency performance. Stay informed about potential risks.

Firstly, assess the risk tolerance and investment objectives to determine an appropriate mix of currencies. Diversify across multiple currencies to spread risk and mitigate exposure to currency fluctuations. Monitor economic indicators, geopolitical events, and market trends to anticipate potential risks and opportunities. Implement risk management strategies such as hedging to protect against adverse currency movements.

Interest rate and currency diversification happen in circumstances where you operate in multiple currencies or you accept deposits from multiple currencies. This may also happen in circumstances where your opportunity cost and swap cost are overweight compared to a high-yielding currency.

Identifying the geographies you operate , define overall the risk tolerance limits, once this basic frame work is in place one can use various markets dynamics to generate alpha either on FX, investments and even borrowings.

Interest rate and currency diversification are vital for mitigating risks associated with fluctuations in interest rates and foreign currency. D Hence, diversifying investments across various interest-bearing instruments and currencies helps protect against losses from adverse movements in rates or exchange rates. It reduces reliance on a single currency or interest rate, increasing the chances of portfolio optimization and more returns.

Adding to Alex’s comment, if you have to hold currencies for operational reasons, entering into basket hedges or collars allows you to protect against big currency movements impacting your balance sheet while still allowing you to receive a return.

Balancing risk and return in currency diversification involve deploying the right strategy. Higher-risk currencies usually offer greater potential returns but come with increased volatility and uncertainty. To mitigate risk, diversifying across currencies with varying risk profiles and correlations is crucial. It's best to pair high-risk currencies with more stable ones as it can offset potential losses. However, close monitoring of your portfolio is important to know when to exist or restrategize.

While it may be tempting to convert cash balances to a currency yielding higher return, in a well-run Treasury function that looks at activities as a whole one can't achieve such a thing. Either the act of conversion creates an exposure that would be hedged, or the exposure existed and would've been hedged anyway. In both cases, assuming efficient markets, economically the return will be exactly the same. Higher yielding currency will result in higher interest income, which will be offset by hedging cost. Leaving exposures unhedged would be speculative and would typically go against the limitations of FX Risk Management Policy of a company.

Use interest rate swaps to convert fixed-rate liabilities to floating rates or vice versa, reducing expenses. Access diverse funding sources like bonds, loans, and commercial paper to spread risk. Implement hedging strategies with options, futures, and swaps; use caps to limit rising rate exposure and floors for falling rates. Structure your debt portfolio with staggered maturities to spread refinancing risk and conduct regular reviews to stay flexible. Scenario analysis helps understand potential impacts and plan strategies. Integrating these methods aligns your assets and liabilities with the interest rate environment, reducing risk.

The great thing about derivatives like interest rate and currency swaps is that they don’t have to start today. They’re incredibly flexible, so you could protect an exposure in a year’s time using a forward starting swap. If there’s something that may or may not happen you could use an option. When I was at Sky which was a GBP company, bids for the champions league (paid in euros) were initially hedged using options and then if successful they moved to a forward and sold the option (options typically cost money up front so that allowed them to get some of their money back).

Interest rate swaps , cross currency swaps and introducing some optionality matched with cashflows can be smartly used to enhance the performance of treasury function.