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Handbook of Exchange Rates by Lucio Sarno, Ian Marsh, Jessica James

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17.3 Benchmarks for Currency Fund Management

In Section 17.2, we described two alternative currency management mandates: a currency overlay mandate and an absolute return mandate.12 Because a currency overlay mandate is often primarily concerned with risk reduction while an absolute return mandate is more focused on generating additional returns, the methodology for benchmarking these mandates differs considerably.

In the case of a currency overlay, the objective is always to hedge some portion of the preexisting currency risk in an asset portfolio. In addition, the mandate may also include the option for the overlay manager to capture some additional return via selective hedging. The currency overlay manager could be evaluated versus a benchmark of performance calculated as if 0% of the underlying exposure were hedged or as if 100% of the exposure were hedged.13 Strange (1998) argues that ultimately the performance of managers evaluated against these benchmarks depends on whether the base currency for measuring performance appreciated or depreciated over the cycle. For this reason, Strange suggests that the 50% hedge ratio became the most popular benchmark. A currency manager is deemed to add value if he outperforms a naive strategy of hedging half the exposure, as if having no expertise to determine whether a currency was rising or falling relative to its forward premium. Strange reports that in his sample of 152 overlay programs managed by 11 firms, on average, 80% outperformed ...

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