JP Morgan - Managing FX Hedge Ratios - A Framework For Strategic and Tactical Decisions

Global FX Strategy
May 26, 2010
Managing FX hedge ratios

A framework for strategic and tactical decisions Unprecedented volatility over the past two years has heightened investor and corporate attention towards managing FX hedge ratios. For investors, four issues predominate: (1) how to determine the longterm, optimal hedge ratio; (2) how to time entry into a hedging program; (3) how to deviate from the strategic hedge ratio to generate profits or manage cash flows; and (4) how to choose between forwards and options in implementing a hedging program. For corporates, the most frequent concerns are variants of the first, second and fourth points: how to set a baseline range for hedge ratios; which currencies are most likely to post large moves higher or lower; and which instruments are best for executing a hedging program. Previous J.P. Morgan research has discussed optimal hedge ratios and proposed currency models based on long-term valuation and short-term momentum. This paper updates those studies, adapts the models for dynamic hedging over various horizons, and extends the original analysis to four base currencies (USD, EUR, GBP, AUD). The conventional wisdom that hedging currency risk minimizes portfolio volatility was proven false at some points during the credit crisis, when hedged portfolios in some currencies became more volatile than unhedged ones. A more dynamic strategy is therefore required to avoid onerous cash flow requirements. Dynamic hedging should begin with signals from long-term fair value models, to indicate which currencies merit the most attention over a 6 to 18-month horizon. Investors can use these signals to time entry into hedging programs, while corporates can use them to focus on currencies most vulnerable to large moves in either direction. Short-term trading models commonly used by currency overlay managers and global macro funds can be adapted to drive deviations around the benchmark hedge ratio over a one to three-month horizon. A price momentum model which adjusts dynamically around a 50/50 hedge ratio outperforms the benchmark by about 100bp annually, depending on the base currency. Information ratios on the strategy range from 0.2 to 0.5. A rate momentum (forward carry) model generates comparable outperformance but with more consistency across sample periods. Data limitations constrain long-term analysis of the efficiency of forwards versus options in a hedging program. But since 2003, options have outperformed forwards for AUD, EUR and GBP-based investors with USD exposure. A signaling model that switches between forwards and options is inconclusive.
www.morganmarkets.com/GlobalFXStrategy J.P. Morgan Securities Ltd.
John NormandAC
(44-20) 7325-5222 john.normand@jpmorgan.com
Gabriel de Kock
(1-212) 834 4254 gabriel.s.de.kock@jpmorgan.com
Matthew Franklin-Lyons
(1-212) 834 4565 matthew.d.franklin-lyons@jpmorgan.com
Arindam Sandilya
(1-212) 834 2304 arindam.x.sandilya@jpmorgan.com
Contents
I. Overview: Four common questions on hedging policy II. The merits of long-term FX exposure III. Using fair value models to focus strategic hedge ratios IV. Using alpha models to adjust hedge ratios tactically V. Hedging with forwards versus options 22 34 16 2 4
The certifying analyst is indicated by an AC. See page 38 for analyst certification and important legal and regulatory disclosures.
Global FX Strategy Managing FX hedge ratios May 26, 2010 John Normand (44-20) 7325-5222 john.normand@jpmorgan.com J.P. Morgan Securities Ltd.
I. Overview: Four common questions on hedging policy

Unprecedented volatility over the past two years has heightened investor and corporate attention towards managing FX hedge ratios. For investors, four issues predominate: how to determine the long-term, optimal hedge ratio for global stock and bond portfolios; how to time entry into a hedging program, to focus on the most expensive currencies and avoid covering exposure in undervalued ones; how to deviate from the strategic hedge ratio to generate profits or manage cash flows; how to choose between forwards and options in implementing a hedging program. For corporates, the most frequent concerns are variants of the first, second and fourth points: how to set a baseline range for hedge ratios; which currencies are most likely to post large moves (higher where they have expenses, lower where they have earnings); and which instruments are best for executing a hedging program. Academic studies and previous J.P. Morgan research over the past two decades have discussed optimal hedge ratios in detail.1 More recent J.P. Morgan studies have proposed long-term valuation and short-term momentum models which can be adapted to answer the second, third and fourth questions (see blue box on next page). This paper updates those studies, adapts the models for dynamic hedging over various horizons, and extends the original analysis to four base currencies (USD, EUR, GBP, AUD). Section II reviews and critiques the conventional wisdom on optimal hedge ratios for those unfamiliar with the framework. Section III applies J.P. Morgans long-term fair value model to answer the investor question of how to time entry into a hedging program, and the corporate question of which currencies merit hedging focus over a 6 to 18-month horizon. Section IV modifies short-term FX trading models (alpha models) based on price momentum and interest rate
Early J.P. Morgan publications include Currency-hedged international fixed income investment, Peter Rappoport (1990); Managing currency risk in global portfolios, Jan Loeys (1999); and Introduction to Portfolio Management, John Normand (2002 and subsequent revisions).
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momentum to drive tactical deviations around a 50/50 hedged benchmark over one to three-month horizons. Section V concludes with a discussion of how these signals can be used to inform the choice of forwards versus options in a hedging program. We find that: The conventional wisdom that hedging currency risk minimises portfolio volatility was proven false at some points during the credit crisis, when hedged portfolios in some currencies became more volatile than unhedged ones. The cash flow implications for some funds was disastrous, hence the necessity to consider more dynamic frameworks for managing hedge ratios over time and across currencies. Long-term fair value models can be the starting point for dynamic hedges, since they can indicate the most vulnerable currencies over the medium term. J.P. Morgans original fair value model (2008) has provided reliable signals for identifying and trading misaligned currencies versus the dollar over 6 to 18-month horizons. That analysis is extended to base currencies such as EUR, GBP and AUD. Investors can use the models signals reported quarterly in flagship publication World Financial Markets and FX Markets Weekly to time the entry into currency overlay programs by raising hedge ratios on the most overvalued currencies, lowering them on the cheapest currencies and remaining at benchmark on others. For corporates, the signals highlight currencies on which hedge ratios should be raised, because the company has expenses in undervalued currencies or earnings in overvalued ones. Over shorter horizons (one to three month rebalancing), tactical trading models commonly used by overlay managers and global macro funds can inform deviations from the benchmark hedge ratio. A price momentum model which adjusts dynamically around a 50/50 hedge ratio outperforms the benchmark by about 100bp annually, depending on the base currency. Information ratios on the strategy range from 0.2 to 0.5. A rate momentum (forward carry) model generates comparable outperformance but with more consistency across sample periods. Data limitations constrain long-term backtesting to compare the efficiency of forwards versus options. Still, since 2003 hedging with options has outperformed forwards for AUD, EUR and GBP based investors with USD exposure. A signalling model which switches between forward and options is inconclusive and will be addressed in more detail in forthcoming research.
Previous J.P. Morgan publications on currency overlay, indices and models available on www.morganmarkets.com/GlobalFXStrategy, or by clicking the hyperlinks below.
Introduction to Portfolio Management, John Normand, 2002 and subsequent revisions. J.P. Morgan effective exchange rates: revised and modernized, Derek Hargreaves and Carl Strong, May 30, 2003. JPMorgans FX Barometer, Normand, Mustafa Caglayan, Dan Ko, Nikolaos Panigirtzoglou and Lei Shen, September 22, 2004. Introducing the JPMorgan VXY & EM-VXY, Normand and Arindam Sandilya, December 11, 2006. JPMorgan Tradeable Currency Indices, Normand, July 2, 2007. Rotating Between G-10 and Emerging Markets Carry, Normand, Jul 9, 2007. A new fair-value model for G10 currencies, Gabriel de Kock, September 6, 2008. Trading and Hedging Long-Term FX Fundamentals with J.P. Morgans Fair-Value Model, de Kock, April 24, 2009. Alternatives to standard carry and momentum in FX, Normand and Ghia, August 8, 2008. The month-end effect in FX: small but predictable, Normand, October 23, 2009.
II. The merits of long-term FX exposure2

The conventional wisdom is that unhedged FX exposure raises volatility more than returns over the long run. This conclusion tends to hold regardless of base currency. There are three exceptions to this conclusion: emerging markets exposure for long-term FX appreciation; G-10 forex exposure as catastrophe insurance; and G-10 forex exposure to diversify portfolio risk. The more-risk-than-return view usually motivates high hedge ratios on fixed income investments. FX hedge ratios on equities are more variable, however. Some investors will hedge to minimise volatility. Others will not due to FXs small marginal contribution to an asset class which is already quite volatile. Cash flow implications can also deter hedging. The credit crisis has forced a rethink of the conventional wisdom and standard practices. USDbased investors suffered massive losses on unhedged portfolios as the dollar strengthened/foreign currencies weakened. Non-US investors who hedged USD exposure incurred significant cash flow obligations from being short the dollar as it appreciated. These developments now motivate many to consider a more dynamic approach to FX risk management.
The notion that passive long-only currency exposure offers no long-term return stems from two conditions in international finance known as covered and uncovered interest parity. Covered interest parity (CIP) states that the interest rate differential between two countries should equal the forward premium (discount), expressed algebraically as rforeign - rdomestic = (FXforward - FXspot)/ FXspot [Equation 1] This relationship is a no-arbitrage condition rather than a theory. Consider the following example. Assume 12-mo Japanese rates are 1%, US rates are 4%, and USD/JPY spot is 110. The no-arbitrage condition in equation 1 implies that the 12-mo forward rate must equal 106.70. If it were 110, an investor could lock in a guaranteed profit by borrowing JPY at 1%, buying a USD deposit at 4% and selling USD forward at 110 for no-risk returns. Uncovered interest rate parity (UIP) is an extension of CIP. If markets are efficient, the forward rate will be an unbiased estimator of the future spot rate. rforeign - rdomestic = (FXexpected - FXspot)/ FXspot [Equation 2] If this condition holds, then there should be no return to taking currency risk, since high (low) interest rate currencies should depreciate (appreciate) to the level of the forward rate. CIP tends to hold in practice, as free capital mobility among the major markets enforces the no-arbitrage condition. The evidence on UIP is mixed, however: the passive return from G-10 currency exposure tends to be negligible over the long-term, but sometimes significant over the short term. One way to illustrate this no-return concept is to consider asset market returns measured from three perspectives: local currency, unhedged into a given base currency and hedged into a base currency. The difference between local currency and unhedged returns is the foreign currencys contribution to total returns. A zero difference would support the view that currency exposure does not augment returns, so perhaps should be hedged if volatility differentials are high. USD-based investors For USD-based investors, the return differential between local currency and unhedged stocks and bonds is modest over the long-term (1988 - 2009).3 Currency moves have augmented asset returns by roughly 1% for investments in the Euro area, Canada, Australia and Japan over the past twenty years, due to those currencies appreciation versus the dollar (charts 1 and 4). Currency has subtracted roughly
Strategic FX exposure: high risk and low return, with three exceptions
The conventional wisdom on FX makes two claims: that FX exposure delivers more risk than return over the longrun; and that FX offers abundant short-term profit opportunities due to structural inefficiencies. If these points are correct, then investors should fully hedge FX exposure but run active overlay programs to capture short-term profit opportunities. Likewise, corporates should hedge as a matter of policy but alter target ratios over shorter horizons when they hold strong directional views.
This section updates and extends analysis on currency management originally published in Introduction to Portfolio Management, John Normand (2002 and subsequent revisions).
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Sample period chosen by the availability of hedged and unhedged return indices across G-10 markets.
Stock and bond returns and volatility with USD as base currency Chart 1: Equity returns hedged vs unhedged into USD, 1988-2009
12% 9% local ccy unhedged hedged
Chart 4: Bond returns hedged vs unhedged into USD, 1988-2009

12% local ccy unhedged hedged
9%
6% 3% 0% -3% USD
Source: J.P. Morgan Source: J.P. Morgan
6%
3%
JPY EUR GBP AUD CAD MSCI ex-US
0% USD JPY EUR GBP AUD CAD GBI ex US
Chart 2: Equity volatility hedged vs unhedged into USD, 1988-2009

Chart 5: Bond volatility hedged vs unhedged into USD, 1988-2009

15% local ccy 12% unhedged hedged
20%
9%
10%
6% 3%
0% USD JPY EUR GBP AUD CAD MSCI exUS
0% USD
Source: J.P. Morgan
JPY
EUR
GBP
AUD
CAD
GBI ex US
Source: J.P. Morgan
Chart 3: Equities for USD-based investors: return vs risk, 1988 - 2009

Return, % 15
Chart 6: Bonds for USD-based investors: return vs risk, 19882009

Return, % 8 6 US bonds World ex US, unhedged World ex US, hedged
10 US equities 5 World ex US, hedged 5 10 15 20 25 Risk, %

-
World ex US, unhedged
4 2
10
15 Risk, %
Source: J.P. Morgan
Source: J.P. Morgan
1% from UK investments due to sterlings depreciation since the late 1980s. Though FXs return impact may be modest, its volatility impact can be significant. For stocks, the difference in annualised volatility between local currency returns and unhedged returns can be massive: 7% - 8% for Australian and Canadian exposure, 3% for UK exposure and 1% for Japanese exposure. Only Euro area stocks exhibit comparable return volatility, whether measured in local currency or unhedged terms (chart 2). Volatility differentials on bonds are also substantial. Unhedged JGB returns in USD terms are 7 percentage points more volatile than local currency returns, and Euro area bonds are 6 points more volatile. The volatility of unhedged returns in UK, Canadian and Australian bond markets are roughly 4 points higher than local currency returns (chart 5). This volatility differential is much more meaningful in bonds than in stocks, since government bonds are already a relatively low-volatility asset class. EUR, GBP and AUD-based investors Similar conclusions hold for investors with other base currencies. For Euro area investors, unhedged overseas exposure has reduced returns by roughly 2% per annum for stocks in the UK, 1.4% for US and less than 1% for Australian and Canadian stocks. Currency moves have had almost no long-term impact on Japanese stocks holdings given that EUR/JPY was close to unchanged between 1989 and 2009 (appendix 1, chart 1). Volatility differences are substantial, however. Unhedged foreign stocks are 3 to 10 percentage points more volatile (appendix 1, chart 2), while foreign bonds are about two times more volatile (appendix 1, charts 2 and 4). For UK investors, unhedged foreign currency exposure has added 1% - 1.9% per annum to stock and bond returns over the past twenty years due to sterlings trend decline (appendix 2, charts 1 and 4). In many cases, however, higher return volatility offsets this return advantage. Unhedged Canadian and Australian stock returns are 5% more volatile, and those in Japan 1.7% more. US stock volatility is only 0.8% higher, but Euro area equity exposure is 0.8% less volatile (appendix 2, chart 2). As a group, unhedged non-UK equities (MSCI ex-UK) add 1.1% per annum to returns but are 2.4% more volatile. For most bond markets, unhedged exposure is two or three times more volatile than local currency returns (appendix 2, chart 5). For Australian investors, the Australian dollars trend appreciation over the past two decades has resulted in a currency loss from unhedged foreign exposure ranging from -0.3% per annum on Euro area investments to -1.7% per annum on UK investments (appendix 3 charts 1 and 4). Exposure to Canadian stocks and bonds has resulted in
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almost no currency loss given the steadiness of the AUD/CAD cross, and Japanese exposure has delivered small currency gains (roughly 0.2%). Volatility differences have been significant, however. Unhedged equity exposure in the US, UK and Canada are roughly 2.5% more volatile than local currency returns, but Euro area and Japanese exposure is 2%-3% less volatile (appendix 3, chart 2). As in other countries, unhedged bond market returns are two to three times more volatile than local currency returns (appendix 3, chart 5).
Three exceptions: emerging markets, catastrophe insurance and portfolio diversifier

Within the G-10, it is generally accepted that FX exposure brings uncompensated volatility over the long run. Since unhedged bond market returns are two to three times more volatile than local currency returns, a strategic or benchmark policy of fully hedging currency risk is sensible. In equities, the hedging decision is less clear-cut. Some investors primarily concerned with risk minimization would hedge. Others would consider a hedging program cumbersome and expensive since FXs marginal contribution to equity volatility over the long run is small; the underlying asset class is already highly volatile. But before delving further into equity investors hedging decision, consider three exceptions to the conventional wisdom that passive FX exposure represents uncompensated risks. These exceptions concern emerging markets exposure, FX as catastrophe insurance and FX as a portfolio diversifier.
Exception 1: emerging markets as a source of long-term returns

Unlike G-10 currencies which tend to mean-revert, emerging market currencies can offer trend positive returns. This excess return stems from two sources real appreciation and carry. Emerging markets currencies often experience long-run real appreciation due to a faster rate of productivity growth (the convergence process). At the same time, interest rates also tend to be above those in G-10 markets, reflecting a higher marginal productivity of capital, a risk premium for convertibility and a policy tool to promote disinflation. This combination of real exchange rate appreciation and interest rate differentials can persist for years (chart 7), and thus generates a meaningful return differential over time to justify their higher risk. We track these excess returns through JPMorgans Emerging Local Markets Index (ELMI), which measures the return in dollars of cash instruments (Libor, T-bills, FX forwards) in 24 emerging markets. Chart 8 shows the Sharpe ratio on the index and its regional sub-components
since 1994. EM FX has outperformed 6-mo dollar cash by 4% annually since the early 1990s. Outperformance has been much higher for convergence countries: Central European currencies have outperformed USD libor by over 7.5% annually, while Latin currencies have outperformed by 1.5%. Risk-adjusted returns on the index are decent (0.42), which is comparable to that on US equities and highgrade credit.
Chart 7: ELMI+ carry and spot returns, 1994-2009
Based on returns from J.P. Morgan ELMI+ index
20% 15% 10% 5% 0% -5% -10% -15% -20% -25% -30% 94 96 98 00 02 04 06 08 -10% -9% -24%
return from FX appreciation/depreciation return from carry
uncertainty or financial crises, local currency would likely weaken versus the G-3, providing some offset to the losses on domestic assets. Finally, investors who have significant foreign currency liabilities such as global pension funds, multinational corporations or central banks likewise match that exposure with unhedged foreign currency assets.
Exception 3: FX exposure may reduce portfolio risk

The third exception which justifies holding unhedged benchmark exposure is for risk diversification: currency and asset risk may be sufficiently negatively correlated so as to lower overall portfolio volatility. Since the variance of a portfolio is the sum of individual variances plus a measure of their comovement, the variance of a portfolio combining a domestic and foreign asset will be a function of the (1) domestic assets variance; (2) foreign assets variance; (3) currencys variance; (4) covariance between the domestic and foreign assets; and (5) covariance between the assets and the currency. This relationship is expressed algebraically as portfolio = w2domestic 2domestic + w2foreign 2foreign + 2 wdomestic wforeign domestic, foreign + H2 2fx + 2H( wdomestic domestic, fx + wforeign foreign, fx) [Equation 3] where H is the proportion of the portfolio with foreign currency exposure. The last two terms capture the impact of currency exposure on total portfolio risk. For the fully hedged portfolio, the variance of the currency exposure will be zero (since H = 0). The last two terms of Equation 3 drop out and the expression reduces to fully hedged = w2domestic 2domestic + w2foreign 2foreign + 2 wdomestic wforeign domestic, foreign [Equation 4] Hedging out the currency risk leaves the variance of the portfolio as a function of the individual asset variances and the covariances between the asset returns, the same as if this were a domestic two-asset portfolio. Under certain conditions, unhedged exposure can reduce overall portfolio volatility. Equation 3 represents the variance of the unhedged (or partially hedged) portfolio, and equation 4 that of the fully hedged portfolio. Rearranging terms (subtracting equation 4 from equation 3) illustrates that currency exposure will reduce total portfolio risk if the following condition holds: w2foreign 2fx + 2 wforeign (wdomesticdomestic, fx + wforeign foreign, fx ) < 0 [Equation 5]
13% 13%
10%
17% 15% 4% -5% -7% 6%
7% 14% 7% -6%
8% 6% 6% 4% -3% 2% 9% 1% 2% -12% 5% 3%
-10% -11%
Source: J.P. Morgan
Chart 8: Emerging markets FX Sharpe ratios, 1994-2009

Based on returns from J.P. Morgan ELMI+ index
0.70 0.61
0.50
0.42
0.30 0.12 0.10 ELMI+ -0.02 Asia ME/Africa Europe Latam 0.14
-0.10
Source: J.P. Morgan
Exception 2: catastrophe insurance and asset/liability matching require unhedged FX exposure

Strategic FX exposure is also useful as a hedge against local event risks, such as political uncertainty and natural disasters. For example, many insurance companies often have significant, unhedged USD holdings. In the event of a natural disaster, the hit to their balance sheets would be partially offset by gains on the local currency value of foreign holdings, assuming the dollar appreciated in response to those developments. Similarly, many investors in emerging markets hold their foreign exposure (in the US, Europe or Japan) unhedged. In the event of political
breakeven FX/asset correlation
In general, the covariance of currency returns with asset returns must be sufficiently negative to overcome the volatility of the currency itself. More specifically, A positive correlation between the assets and the currency increases total portfolio risk; If sufficiently large, a negative correlation between assets and the currency can offset currency volatility; If there is zero correlation between the currency and the foreign asset, the currencys correlation with the domestic asset must be more negative in order to reduce total portfolio volatility; If currency returns are less volatile than asset returns, the negative correlation can be somewhat closer to zero and still reduce portfolio volatility. How negative must the correlation be for currency exposure to lower portfolio variance? Consider an example in which the volatility of the domestic and foreign assets are equal, and the domestic and foreign asset correlations with the currency are equal. In this case, Equation 3 reduces to foreign, fx < -wforeign fx / 2foreign [Equation 6] Plugging in various volatilities for the assets and currency and different allocations to foreign assets generates breakeven correlations which reduce total portfolio risk. For example, if the currency and asset returns are equally volatile (vol ratio = 1, as in chart 9) and 10% of the portfolio is allocated to foreign assets, then the correlation between currency and asset returns would need to be more negative than -0.05 in order to lower overall risk. If 50% of exposure were foreign, the correlation would need to be more negative than -0.25. If the currency were more volatile than the asset market (vol ratio = 1.2), then the breakeven correlations would need to be even more negative for a given foreign allocation in order to reduce portfolio volatility. In practice asset/FX correlations are neither sufficiently nor consistently negative to reduce portfolio volatility by leaving currency exposure unhedged. For USD-based investors over the past two decades, only European stocks have correlated negatively with their currency performance versus the dollar, implying that their currencies depreciate versus the dollar when equities rise (chart 10 and table 1).
Chart 9: Threshold correlation for portfolio risk reduction

0.00 -0.10 -0.20 -0.30 -0.40 -0.50 -0.60 -0.70 100% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% vol ratio = 1.2 vol ratio = 1.0 vol ratio = 0.5
percent allocation to foreign equities
Source: J.P. Morgan
Chart 10: Correlation of foreign stocks and FX, 1990-2009 for USDbased investor
Based on monthly returns over 3 year rolling window
0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 90 93 96 99 02 05 08 EUR GBP
Source: J.P. Morgan
Chart 11: Correlation of foreign stocks and FX, 1990-2009 for USDbased investor
Based on monthly returns over 3 year rolling window
0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 90 93 96 99 02 05 08 CAD AUD JPY
Source: J.P. Morgan
But that apparent diversification benefit disappears over a ten-year sample period (correlations close to zero) and over a five-year sample (the long-term correlation has flipped to positive). Correlations between Australian/Canadian equities and their currencies versus the dollar have always been positive (chart 11 and table 1), which thus makes unhedged equities more volatile for US investors. The correlation between the Nikkei and the yens performance versus the dollar has been negative, but the strength of this relationship varies over time. For euro and sterling-based investors, the dollars performance versus the euro has correlated negatively with US stocks over the past five years (higher stocks, lower dollar), but not over the past twenty years. Commodity currency moves versus the euro and sterling correlate positively with their equities, which makes unhedge
exposure riskier. Yen correlations are negative but sometimes not strong enough to diversify risk. The atypical market is Australia. The combination of yield and commodity exposure leads AUD to rise (and foreign currencies to fall) when equities rise. Viewed in isolation this feature lends diversification benefit to unhedged foreign exposure, but given the AUDs long-term appreciation trend, unhedged exposure also subjects local investors to a translation loss. For bonds, many currencies correlate negatively with fixed income performance, which suggests diversification benefits from leaving exposure unhedged. Correlation is only half the picture, however. Since currency volatility is so much higher than bond market volatility, even high and consistently-negative correlations are insufficient to reduce portfolio volatility. This point is illustrated by the appendix charts at the end of Section II.
Table 1. Correlations between currencies, stocks and bonds from the perspective of four based currencies (USD, EUR, GBP and AUD)
Correlations between asset market performance and foreign currency performance versus base currency. For example, a positive correlation of 0.18 for Euro area stocks with USD as base currency implies that the euro tends to rise versus the dollar when European stocks rise. Correlations based on monthly return data. Foreign currency Base currency USD Foreign asset bonds stocks bonds stocks bonds stocks EUR bonds stocks bonds stocks bonds stocks GBP bonds stocks bonds stocks bonds stocks AUD bonds stocks bonds stocks bonds stocks
Source: J.P. Morgan
Sample period 2005 - 09 (5 years) 2000 - 09 (10 years) 1990 - 2009 (20 years) 2005 - 09 (5 years) 2000 - 09 (10 years) 1990- 09 (20 years) 2005 - 09 (5 years) 2000 - 09 (10 years) 1990 - 2009 (20 years) 2005 - 09 (5 years) 2000 - 09 (10 years) 1990 - 2009 (20 years)
USD NA NA NA NA NA NA 0.04 -0.33 -0.13 -0.09 -0.16 0.00 0.49 -0.24 0.19 -0.09 0.02 -0.04 0.26 -0.49 0.12 -0.33 0.11 -0.25
EUR -0.29 0.18 -0.04 -0.02 -0.09 -0.12 NA NA NA NA NA NA 0.25 0.05 0.24 -0.02 0.18 -0.12 0.28 -0.44 0.28 -0.36 0.07 -0.22
GBP -0.48 0.04 -0.29 -0.04 -0.21 -0.12 -0.58 -0.16 -0.49 -0.09 -0.23 0.00 NA NA NA NA NA NA -0.37 -0.48 -0.20 -0.39 -0.12 -0.26
AUD -0.56 0.40 -0.34 0.25 -0.17 0.19 -0.58 0.47 -0.50 0.39 -0.19 0.24 -0.12 0.39 -0.14 0.33 -0.07 0.17 NA NA NA NA NA NA
CAD -0.46 0.29 -0.27 0.25 -0.04 0.26 -0.52 0.01 -0.44 0.14 -0.11 0.21 -0.05 0.01 -0.06 0.13 -0.02 0.14 -0.29 -0.30 -0.23 -0.19 -0.04 -0.13
JPY 0.35 -0.34 0.14 -0.20 0.04 -0.08 0.19 -0.29 -0.03 -0.12 -0.04 -0.03 0.42 -0.32 0.15 -0.19 0.05 -0.10 0.25 -0.36 0.11 -0.27 0.08 -0.17
Global FX Strategy Managing FX hedge ratios May 26, 2010 John Normand (44-20) 7325-5222 john.normand@jpmorgan.com J.P. Morgan Securities Ltd
The optimal hedge ratio: no size fits all

In the final balance, what hedge ratio makes sense strategically? There is no uniform, strategic hedge ratio. The appropriate policy is particular to the investor given four variables: (1) the allocation between domestic and international assets; (2) the currency allocation of foreign assets; (3) the consistency of historical volatilities and correlations in the future; and (4) the investors risk preference. The optimal hedge ratio therefore will vary by investor and over time. While there are no absolutes, several guidelines apply to the merits of fully hedged, unhedged and semi-hedged benchmarks. For investors in G-10 bonds, FX exposure should be mostly hedged given how currency volatility often drives overall portfolio risk. The exceptions are for catastrophe insurance and asset/liability matching discussed on page 7. FX hedge ratios for equity portfolios are more debatable. For investors concerned mainly with minimising volatility over the long term, 100% hedged benchmarks are lower variance than unhedged ones for USD, EUR and GBP-based investors given the generally positive correlation between foreign currency performance and foreign equity markets. The opposite holds for AUD-based investors: unhedged portfolios are less volatile over the long term. Even for those investors seeking to minimise volatility, 100% hedged benchmarks entail important limitations. Full hedging eliminates potential short-term gains from tactical trading. Given the profitability of active currency managers and rule-based trading strategies, 100% hedging precludes a potential alpha opportunity. Section III discusses this issue in more detail. Even a 100% hedge ratio with the flexibility to deviate from the policy is quite constrained. If the benchmark is 100% hedged against the base currency, the manager may hedge less than the benchmark but not more. Thus the manager can only outperform the benchmark in environments when the foreign currency is rising.
Chart 12: Volatility of hedged and unhedged S&P500 returns for GBP-based investors, 1988-2010
Based on monthly returns over rolling 12 month window
35% 30% 25% 20% 15% 10% 5% 0% 88 90 92 94 96 98 00 02 04 06 08
Source: J.P. Morgan
unhedged
hedged
Chart 13: Volatility of hedged and unhedged S&P500 returns for AUD-based investors, 1988-2010
35% 30% 25% 20% 15% 10% 5% 0% 88 90 92 94 96 98 00 02 04 06 08
Source: J.P. Morgan
unhedged
hedged
Chart 14: Volatility of hedged and unhedged Nikkei returns for USDbased investors, 1988-2010
50% 40% 30% 20% 10% 0% 89 92 95 98 01 04 07 10 unhedged hedged
Source: J.P. Morgan
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Full hedging can also impose substantial cash flow requirements during period of extreme market stress, such as the 2008-09 credit crisis. Ironically in 2008, some investors found their fully-hedged benchmarks to be even more volatile than unhedged ones because they were short a foreign currency which was appreciating as the foreign equity market fell. In some cases investors were forced to liquidate underlying assets to fund the cash flow obligations of a currency hedging program, thus reinforcing the decline in equity and currency markets. Semi-hedged benchmarks (50/50) faced a similar dilemma, although to a lesser degree Such would have been the predicament of UK and Australian investors who hedged the currency risk on S&P500 exposure (so were short USD vs GBP and AUD as both currencies collapsed), or US hedgers who were short the yen as an overlay to their Nikkei investments. Charts 12 14 highlight how, for the first time in decades, unhedged equity returns were more volatile than hedged ones. In those case where a zero hedge ratio seems sensible long-term due to a negative correlation between foreign currency and equity returns the case in foreign equities from an AUD perspective such a policy could expose investors to substantial short-term volatility. And an unhedged benchmark limits flexibility as much as a 100% one does. If the benchmark is unhedged against the base currency, the manager may hedge more than the benchmark but never less. Thus the manager can only outperform the benchmark in an environment when the foreign currency is depreciating.
Chart 15: Performance with and without overlay

12% pass-through to investor 9% 6% 3% 0% -3% -6% -9% -12% -12% -9% -6% -3% 0% 3% 6% 9% 12% currency return
Source: J.P. Morgan
symmetric hedge + overlay
unhedged
which allows the investor to participate in currency gains while avoiding currency losses (chart 15). It is thus the policy of least regret for many investors. Even if the 50/50 policy appeals intuitively as a benchmark, many situations require a more dynamic approach, particularly for those investors concerned about entry levels, cash flows and profit opportunities. Sections III and IV of this paper address these issues in more detail by applying fair value and momentum models.
50/50 hedge ratio as policy of least regret

Given the particulars of investor or corporate exposure and the tradeoffs inherent in various policy options, risk managers have two options for selecting the optimal hedge ratio. They can run a mean-variance optimization to determine the minimum variance hedge ratio, then overlay some discretion in the final policy decision. Alternatively they can adopt a symmetric benchmark hedge ratio of 50%. Symmetric benchmarks appeal because they address the risk inherent in overseas investing; allow flexibility to manage cash flow; and minimize the risk of overfitting inherent in mean-variance optimization. They also allow investors to capture profit opportunities. With symmetry, if managers believe the base currency will appreciate, they can hedge the foreign currency. If they expect the base to depreciate, they can buy additional foreign currency exposure over the benchmark. The payoff structure resembles a zero cost call option on the currency
11
Appendix 1: Stock and bond returns and volatility with EUR as base currency Chart 1: Equity returns hedged vs unhedged into EUR, 1989-2009
12% 9% 6% 3% 0% -3% -6% EUR
Source: J.P. Morgan
Chart 3: Bond returns hedged vs unhedged into EUR, 1993-2009

local ccy
unhedged
hedged
6%
3%
JPY
GBP
USD
AUD
CAD
MSCI ex-EU
0% EUR
Source: J.P. Morgan
JPY
GBP
USD
AUD
CAD
GBI
Chart 2: Equity volatility hedged vs unhedged into EUR, 1989-2009

Chart 4: Bond volatility hedged vs unhedged into EUR, 1993-2009

20%
10%
10%
5%
0% EUR
Source: J.P. Morgan
JPY
GBP
USD
AUD
CAD
MSCI ex-EU
0% EUR JPY GBP USD AUD CAD GBI
Source: J.P. Morgan
Chart 3:Equities for EUR-based investors: return vs risk, 1988 2009

Return, %
20 15 10 5 10 15 20 25 30 Risk, % World ex Euro area, hedged World ex Euro area, unhedged
Chart 6: Bonds for EUR-based investors: return vs risk, 1993 - 2009

Return, % 20 15
Euro area equities
10 Euro area bonds 5 World ex Euro area, hedged 5 World ex Euro area, unhedged 10 15 Risk, %
Source: J.P. Morgan
12
Appendix 2: Stock and bond returns and volatility with GBP as base currency Chart 1: Equity returns hedged vs unhedged into GBP, 1988-2009
12% local ccy 9% 6% 3% 0% -3% GBP
Source: J.P. Morgan
Chart 4: Bonds hedged vs unhedged into GBP, 1993-2009

18% local ccy 15% 12% 9% 6% 3% unhedged hedged
unhedged
hedged
JPY
EUR
USD
AUD
CAD
MSCI ex-UK
0% GBP
Source: J.P. Morgan
JPY
EUR
USD
AUD
CAD
GBI ex UK
Chart 2: Equity volatility hedged vs unhedged into GBP, 1988-2009

30% 25% 20% local ccy unhedged hedged
Chart 5: Bond volatility hedged vs unhedged into GBP, 1993-2009

25% 20% 15% local ccy unhedged hedged
15% 10% 5% 0% GBP

Source: J.P. Morgan
10% 5% 0% GBP
Source: J.P. Morgan
JPY
EUR
USD
AUD
CAD
MSCI exUK
JPY
EUR
USD
AUD
CAD
GBI ex UK
Chart 3: Equities for GBP-based investors: return vs risk, 1988 - 2009

Return 25 20
Chart 6: Bonds for GBP-based investors: return vs risk, 1993 - 2009

Return 20 15
15 10 5 15 20 25 Risk
10
UK bonds World ex UK, unhedged
UK equities
World ex UK, unhedged World ex UK, hedged

5 5
World ex UK, hedged
10
15 Risk
Source: J.P. Morgan
Source: J.P. Morgan
13
Appendix 3: Stock and bond returns and volatility with AUD as base currency Chart 1: Equity returns hedged vs unhedged into AUD, 1988-2009
12% 9% 6% 3% 0% -3% AUD
Source: J.P. Morgan
Chart 4: Bonds hedged vs unhedged into AUD, 1993-2009

local ccy
unhedged
hedged
6%
3%
JPY
EUR
USD
GBP
CAD
MSCI world
0% AUD
Source: J.P. Morgan
JPY
EUR
USD
GBP
CAD
GBI ex AUD
Chart 2: Equity volatility hedged vs unhedged into AUD, 1988-2009

Chart 5: Bond volatility hedged vs unhedged into AUD, 1993-2009

20%
15% 10% 5%
10%
0% AUD
Source: J.P. Morgan
0%
JPY
EUR
USD
GBP
CAD
MSCI world
AUD
Source: J.P. Morgan
JPY
EUR
USD
GBP
CAD
GBI ex AUD
Chart 3: Equities for AUD-based investors: return vs risk, 1988 - 2009

Return
20 15 10 5 15 20 25 Risk
Chart 6: Bonds for AUD-based investors: return vs risk, 1988 - 2009

Return
10 8 6 World, hedged World, unhedged Australia bonds
Australia equities
World, hedged World, unhedged -
4 2
10
15
20 Risk
Source: J.P. Morgan
Source: J.P. Morgan
14
Appendix 4: Emerging market bond returns and volatility with USD as base currency Chart 1: Emerging market bond returns, 2002-2009
Annual %, USD terms, based on J.P. Morgan EM-GBI
20% local ccy 15% 10% 5% 0% EM-GBI GBI-EM Europe GBI-EM Asia GBI-EM Latam GBI-EM Mideast & Africa unhedged hedged
Source: J.P. Morgan
Chart 2: Emerging market bond volatility, 2002-2009

Annual %, USD terms, based on J.P. Morgan EM-GBI
30% 25% 20% 15% 10% 5% 0% EM-GBI GBI-EM Europe GBI-EM Asia GBI-EM Latam GBI-EM Mideast & Africa local ccy unhedged hedged
Source: J.P. Morgan
15
Global FX Strategy Managing FX hedge ratios May 26, 2010 Gabriel de Kock (1-212) 834-4254 gabriel.s.de.kock@jpmorgan.com JPMorgan Chase Bank NA
III. Using fair value models to focus strategic hedge ratios4

100% hedging can create onerous cash flow obligations, 0% hedging leaves investors and corporates too exposed to exchange rate swings, and a 50% hedge ratio strikes some as arbitrary. An alternative strategy would focus hedging on the most misaligned currencies: hedge expensive pairs, not cheap ones. J.P. Morgans fair long-term fair value model can inform this process. The model derives fair value estimates for G-10 currency cross rates from the long-term relationship between real trade-weighted exchange rates and fundamental economic drivers. FX misalignments are statistically and economically significant in predicting currency moves out of sample over 6-, 12- and 18-month horizons. A back test over the 2004-08 period shows that trading rules exploiting misalignments consistently outperform carry. By implication, adjusting medium-term hedge ratios in response to misalignments should improve portfolio performance or reduce hedging costs.
exchange rates. It explains our approach to modelling fair values, the drivers of fair value exchange rates and their empirical importance, and the models performance in guiding currency investment and hedging decisions. The fair-value exchange rate model is designed as an objective method for estimating exchange rate benchmarks that would be sustainable over longer time horizons between one and a half and five years. It takes a multicurrency approach to fair value exchange rates, defining fair values in terms of trade-weighted exchange rates. Starting from the presumption that real trade-weighted exchange rates vary systematically with long-run economic fundamentals, the model defines the relationship between real trade-weighted exchange rates and their fundamental drivers as the long-run equilibrium (or sustainable) real exchange rates (ERER). Estimated ERER, together with trade weights and historical bilateral nominal exchange rates are used to calculate mutually consistent fair-value bilateral nominal exchange rates.
Long-term FX fundamentals
The fundamental drivers of long-term equilibrium real exchange rates in JP Morgan's fair-value model are those that economic theory suggests should affect a wide range of currencies over a wide range of time periods and circumstances. These variables and their expected impacts on the ERER are: Terms of Trade: A rise in the terms of trade (export prices relative to import prices) increases profits and incomes and hence national wealth, attracting capital inflows and boosting capex and consumer demand. Rising demand tightens capacity constraints, driving up real interest rates and thereby attracting foreign capital. As a result, the ERER impact of the terms of trade is proportional to the openness of the economy and the duration of the terms of trade change. Current account balance and external debt: We interpret a current account deficit as a capital account surplus, reflecting the attractiveness of domestic assets in the global marketplace and the fact that capital can cross borders instantaneously, while trade and investment flows change slowly over time. In short, a rising current account deficit is associated with exchange rate appreciation. However, a country cannot run a current account deficit spending more than it earns forever. Persistent external deficits imply an accumulation of external debt and rising debt service payments to foreign investors. Thus, higher foreign liabilities require a weaker currency to generate the increase in export earning to service the debt. Government debt: High levels of government debt depreciate the currency over the long run, because
If 100% hedging can create cash flow problems in highvolatility environments, and zero hedging leaves investors and corporates too exposed to exchange rate swings, what are the alternatives? From a strategic perspective, investors and corporates could focus hedging activity on those currencies which are most misaligned. Very expensive currencies would seem most vulnerable to a fall, so should be fully or mostly hedged over a medium-term horizon such as one year. Very cheap currencies would be biased to appreciate over time, so should be left unhedged or partially hedged over the medium term. Determining which currencies qualify as cheap or expensive is a valuation exercise, for which we employ a fair value framework developed in 2008 (see footnote). This section summarizes J.P. Morgans fair-value model for the G-10
4
This section updates and extends to other base currencies the fair value model outlined in two previous publications: A new fair value model for G10 currencies (September 6, 2008) and Hedging and trading long-term FX with J.P. Morgans fair value model (April 24, 2009), both by Gabriel de Kock.
16
government borrowing crowds out private borrowing and investment, lowering potential economic growth and longterm asset returns and raises expected future tax rates and inflation rates, both of which tend to undercut long-term asset market performance. Inflation: High inflation typically reflects bad economic policies and is associated with high inflation volatility, both of which distort resource allocation lowering the return on capita and the ERER.
in the economic drivers are of the expected sign and magnitude. Moreover, the analysis attributes about onequarter of the swings in observed real exchange rate to shift in the underlying fair value. Charts 1 and 2 illustrate historical real equilibrium exchange rate estimates for the USD and the AUD. Strikingly, the estimated real fair value of the USD appears quite stable over time compared to the swings in the market real exchange rate, while most of the swings in the AUD real exchange rate are attributed to swings in its fair value. The key difference between the two currencies is that as a commodity price-driven swings in Australias terms of trade account for much of the swings in the real AUD and hence for much of the swings in its fair value. By contrast, the US with its well-diversified import and export baskets experiences mild terms of trade swings over time and those swings, given that the US is a relatively closed economy have only a small impact on the real exchange rate. Our latest fair value estimates for G-10 real trade-weighted exchange rates and bilateral exchange rates vs. the USD are shown in Tables 2 and 3. Table 2 highlights that, as of March, the USD and EUR were close to fairly valued in real-trade-weighted terms, while GBP was about 15% undervalued and the JPY 11% overvalued. However, on average, deviations from fair value had declined notably since 2009 Q3, led by NOK, SEK, CAD, and EUR.
Table 1: Estimated long-run equilibrium real exchange rate model, 1980-1Q08 Driver Estimate Permanent
Log(RER) Log(Terms of Trade) x Openness Current Account Balance (% GDP) Net Inv estment Income (% GDP) Gov ernment Debt (% GDP) Inflation (%) 1.3429 (26.86) -1.2971 (-10.09) 0.4755 (2.02) -0.2331 (-12.27) -0.6427 (-1.92) 0.2637 0.9869 -0.9550 0.3501 -0.1716 -0.4732
Estimating fair values

We estimate the fair-value exchange rates in three steps. First, we use a panel cointegration analysis to estimate the stable long-term relationship between the real exchange rate and its fundamental drivers. This step combines data from all of the G-10 economies and by assuming that the fundamental drivers affect real exchange rates similarly across countries, allows us to estimate a long-term relationship with relatively short data spans. Next, we use the parameters of the estimated long-term relationship and observations on the fundamental drivers to find the equilibrium or fair-value real exchange rates. However, period-to-period swings of the drivers contain transitory noise that distorts the estimates when plugged into a relationship designed to capture long-term shifts. To compensate, we scale down the elasticities on the fundamental drivers in proportion to the relative importance of transitory noise in their period to period fluctuations. And, reflecting the forward-looking nature of financial markets, to the extent that real observed real exchange rate changes predict future shifts in the permanent component of the macroeconomic drivers, we incorporate a fraction of period-to period changes in the observed real exchange in the estimated long-run equilibrium real exchange rate. To determine the appropriate scale factor, we use time-series techniques to decompose the data into permanent and temporary components. Finally, we use the our estimated long-run equilibrium real exchange rates obtained from this decomposition, along with trade weights and historical nominal exchange rates, to calculate fair-value bilateral nominal exchange rates. Intuitively, since price levels at each point in history are given, all of the real misalignment can be attributed to nominal misalignments. So, we use the trade weights to distribute nominal misalignments across the G-10 to match, simultaneously, the real misalignments of all of the G10 countries. Table 1 shows the equation used to estimate the G10 equilibrium real exchange rates, with the scaled-down coefficients denoted as permanent. The elasticities measuring the equilibrium real exchange rate impact of shift
R = 0.88
Note: Standard errors in parentheses. Source: J.P. Morgan
17
The EUR, CHF, CAD and AUD were less than 3% mispriced against the USD in 1Q10, while GBP, NOK and SEK remained cheap and JPY the most persistently overvalued G10 currency.
Chart 1: Equilibrium and actual real trade-weighted USD, 1980-1Q10

160 150 140 130 120 110 100 80
Source: J.P. Morgan
Actual
Fair Value
Currency misalignments as signals for hedging/investment decisions

In most quarters, the JP Morgan fair value model identifies significant misalignments among the G-10. At the most recent update of the fair value estimates in mid-March 2010 the average misalignment against the USD stood at 5.2%. But, as Table 4 shows, the misalignments are much more extreme for some G-10 crosses, particularly for GBP and JPY. For example, JPY was 13% overvalued against CHF, 15% against SEK and 19% against NOK, while GBP was more than 20% undervalued against AUD, CAD and NZD. Misalignments relative to fair value predict exchange-rate changes out of sample, particularly over 12-18-month horizons, suggesting that using deviations from fair value into account in hedging decisions could improve portfolio performance. Below we demonstrate that a simple buy-andhold trading rule acting when misalignments exceeded the cost of carry generally outperformed the forwards over 6-, 12- and 18-month horizons, typically performing best over 6-month investment horizons. Of course the usual caveat applies to these results: they reflect FX developments in a particular time period, and cannot prove that using the fairvalue model in this manner would necessarily produce profits in the future. A back test of fair value signals To assess whether the fair-value model provides useful trading/hedging signals, we back-test a simple buy-and-hold trading rule. For a signal to go long or short FX against a base currency, we compare its misalignment with its forward premium or discount as follows: (a) go short foreign currency, buying 1 unit of the base currency forward if the percentage overvaluation of the foreign currency exceeds its forward discount (and hence the cost of carry) by more than a predetermined critical or threshold value. Reverse the position at the spot rate when the forward contract matures. Similarly, (b) go long FX, selling $1 forward if the percentage undervaluation of foreign currency exceeds its forward premium by more than the predetermined threshold and reverse the position at the spot rate when the forward contract matures.
85
90
95
00
05
10
Chart 2: Equilibrium and actual real trade-weighted AUD, 1980-1Q10
105 Actual 95 85 75 65 55 80
Source: J.P. Morgan
Fair Value
85
90
95
00
05
10
Table 2: G-10 actual and fair-value real trade-weighted exchange rate indexes (2Q09=100), 2Q09-1Q108
2Q09 Actual USD EUR JPY GBP CHF CAD AUD NZD NOK SEK 100 100 100 100 100 100 100 100 100 100 FV 99.6 96.6 92.3 120.2 103.4 108.2 105.3 102.2 116.9 108.3 3Q09 Actual 96.2 101.6 100.7 102.4 98.9 103.9 106.3 108.5 104.6 103.0 FV 98.3 97.3 92.5 120.4 102.7 111.2 107.3 101.2 118.1 111.6 4Q09 Actual 93.1 102.9 101.9 100.1 101.2 107.7 110.9 114.0 109.2 102.7 FV 96.4 97.2 92.0 118.5 104.2 111.9 109.4 106.4 119.0 111.4 1Q10 Actual 94.9 96.1 102.3 101.3 102.0 109.5 109.5 113.2 110.6 106.7 FV 96.8 95.8 92.1 118.8 104.4 112.3 109.1 106.2 119.3 112.3
Note: Exchange rates are quarterly averages. Source: J.P. Morgan.
18
The objective of the back test is to determine whether there are values of the threshold for which this trading strategy would have yielded profits in excess of carry. The back-test covers the period from 1Q04 to 4Q08 and is based on 21 sequential estimates of the fair value model on data samples from 1Q80 to 4Q03 through 1Q80 to 4Q08. To accurately reflect the time lags in the availability of the data used in estimating fair values, we measure misalignments relative to the quarterly fair value estimate lagged one quarter. And to mimic a realistic trading environment we assume that transactions occur in the first trading week of every quarter and at the averages of the forward and spot rates over the first five trading days of the quarter. And the signal is derived by comparing the average forward rates over the first five trading days of the quarter to the quarterly fair-value estimate. Finally, for ease of interpretation and to explore the robustness of the results we report back-tests for USD-, EUR-, GBP-, and AUD-based investors and corporates. USD-based investors and corporates Table 5 shows the results of the strategy for a USD-based investor or corporate over 6-, 12- and 18-month horizons (two, four and six quarters) and decision threshold values at 0%, 5% and 10%. The strategy outperformed carry, on average, performing best over 6-month investment horizons irrespective of the size of the decision threshold. As expected, the strategy is more profitable for greater initial misalignments, that is, for higher threshold values. Indeed, in our sample, acting on initial carry-adjusted misalignments greater than 10% outperforms carry by about 3.6% over a 6-month horizon, about one-and-a-half times the average return for a 0% threshold. A 10% misalignment threshold might seem large. In Table 4, only the JPY and GBP were misaligned by more than 10% against the USD in mid-March. But for the G10 currencies 19 out of 45 crosses were misaligned by more than 10%. Finally, irrespective of the decision threshold, the profitability of the buy-and-hold strategy deteriorated over longer holding periods.
Table 3: G-10 actual and fair-value bilateral exchange rates vd USD, 2Q09-1Q10
2Q09 Actual EUR/USD USD/JPY USD/CHF 1.36 97 1.11 FV 1.36 105 1.84 1.07 1.10 0.79 0.61 5.47 7.19 3Q09 Actual 1.43 94 1.64 1.06 1.10 0.83 0.67 6.11 7.28 FV 1.39 103 1.86 1.05 1.05 0.81 0.60 5.47 6.81 4Q09 Actual 1.48 90 1.63 1.02 1.06 0.91 0.73 5.69 7.01 FV 1.41 101 1.85 1.03 1.03 0.86 0.65 5.31 6.61 1Q10 Actual 1.39 90 1.57 1.06 1.05 0.90 0.71 5.84 7.19 FV 1.41 100 1.83 1.03 1.04 0.88 0.65 5.35 6.75
GBP/USD 1.55 USD/CAD 1.17 AUD/USD 0.76 NZD/USD USD/SEK 0.60 7.91 USD/NOK 6.50
Note: Exchange rates are quarterly averages. Source: J.P. Morgan.
Table 4: G-10 bilateral exchange rate deviations from 1Q10 fair values (%), 12-18 Mar 10
EUR USD EUR JPY GBP CHF CAD AUD NZD NOK
Misalignments measured as average market rates for 12-18 Mar vs 1Q10 fair values. A negative number denotes undervaluation of the column currency vs the row currency. Source: J.P. Morgan.
JPY 10.4 13.5
GBP -18.6 -15.5 -29.0
CHF -2.9 0.2 -13.3 15.7
CAD 2.0 5.2 -8.4 20.6 4.9
AUD 4.5 7.7 -5.8 23.2 7.5 2.5
NZD 9.0 12.2 -1.4 27.6 12.0 7.0 4.5
NOK -8.8 -5.7 -19.2 9.8 -5.9 -10.8 -13.4 -17.8
SEK -5.0 -1.8 -15.3 13.7 -2.0 -6.9 -9.5 -14.0 3.9
-3.2
19
Table 5: USD as base currency - profitability of fair value-based trading rules (% annual, net of carry), 2004-08
Threshold = 0% Horizon 2 4 6 Horizon 2 4 6 Horizon 2 4 6 Avg. 2.3% 0.4% 0.2% Avg. 2.6% 0.5% 0.3% Avg. 3.6% 1.1% 0.8% AUD 2.9% -0.4% -1.5% AUD 2.4% -1.1% -1.4% AUD 4.5% 2.3% 1.7% CAD 2.9% 3.4% 1.8% CAD -0.9% 2.1% 0.8% CAD NA NA NA EUR -0.4% -2.1% -1.9% EUR -0.4% -2.1% -1.9% EUR 2.5% -0.4% -1.1% JPY 2.9% 1.3% 2.0% Threshold = 5% JPY 1.1% 0.5% 2.8% Threshold = 10% JPY -0.9% 1.6% 1.6% NOK 3.3% 0.7% 0.1% NZD 5.5% 0.4% 1.3% SEK 6.4% 1.7% 0.9% CHF 1.2% -0.8% -0.3% GBP 6.1% 3.2% 2.1% NOK 3.0% -0.5% -0.4% NZD 7.2% 2.9% 1.8% SEK 4.3% 0.3% -0.5% CHF 0.5% -0.6% -0.3% GBP 6.5% 3.2% 1.3% NOK 2.1% -1.5% -0.6% NZD 3.5% 2.8% 2.7% SEK 2.9% 0.0% -0.6% CHF 0.5% -0.6% -0.3% GBP 2.9% 0.4% -0.1%
Note: NA reflects situations when there were no trades for a particular currency and time horizon. Source: J.P. Morgan
EUR-based investors and corporates Among the four base currencies considered here, the G-10 fair value model is the least successful in generating excess returns for EUR-based investors or corporate hedgers. As for USD-based investors, positions taken on the basis of fair value model signals generate excess returns over carry, but the excess returns are modest about one-fifth on average the excess returns enjoyed by USD-based decision-makers. And more clearly than elsewhere the signals are more valuable at higher decision thresholds, albeit by a relatively small return margin. Consistent with the patterns observed for USD-based investors, EUR/USD positions always underperformed interest rate spreads, irrespective of the decision horizon or the reaction threshold. This outcome appears to reflect the specifics of the sample period used. The euro trended above and away from its fair value for most of our back-test sample the powerful trend reversal in the second half of 2008 simply came too late to affect the overall results, but would have done so if we had extended the sample to allow more positions to mature.
Table 6: EUR as base currency - profitability of fair value-based trading rules (% annual, net of carry), 2004-08
Threshold = 0% Horizon 2 4 6 Horizon 2 4 6 Horizon 2 4 6 Avg. 0.2% 0.0% 0.2% Avg. 0.5% 0.4% 0.3% Avg. 0.6% 0.6% 0.1% AUD -0.9% 0.9% 1.2% AUD 0.7% 2.1% 1.5% AUD NA 0.5% 0.3% CAD NA 0.7% NA CAD NA 0.7% NA CAD NA 1.5% NA USD -0.4% -2.1% -1.9% USD -0.4% -2.1% -1.9% USD 2.5% -0.4% -1.1% JPY 2.0% -2.0% 0.7% Threshold = 5% JPY 2.9% 0.4% 0.7% Threshold = 10% JPY 5.6% 2.5% 0.8% NOK -0.1% -0.1% NA NZD -2.6% 0.1% 0.7% SEK NA NA NA CHF 0.2% 0.5% NA GBP -1.7% NA NA NOK 0.5% 0.0% -0.1% NZD 1.4% 1.3% 0.0% SEK -2.2% 0.2% NA CHF 1.4% 1.0% 0.8% GBP -0.7% 0.1% 0.7% NOK -1.3% 1.9% 0.3% NZD 4.2% 0.1% 0.1% SEK -2.0% 0.0% 1.0% CHF 3.4% 3.0% 2.1% GBP -3.4% -2.5% -1.6%
Note: NA reflects situations when there were no trades for a particular currency and time horizon. Source: J.P. Morgan
20
GBP-based investors and corporates The results of the misalignment-driven buy-and hold strategy for a GBP-based decision-maker are shown in Table 7. In comparison with the results using the USD as the base currency, the performance of the model is quite consistent over decision thresholds and investment horizons. In general, an investment strategy based on the fair value signals outperformed carry by more than
2% annually on average and the deterioration in performance over longer decision horizons appears quite modest. But, by the same token, waiting for large initial misalignments does not consistently improve performance. Also, before late 2008, GBP misalignments tended to be modest. As a result, the decisions based on a 10% action threshold resulted in a very small number of positions and, therefore, the result are potentially less reliable.
Table 7: GBP as base currency - profitability of fair value-based trading rules (% annual, net of carry), 2004-08
Threshold = 0% Horizon 2 4 6 Horizon 2 4 6 Horizon 2 4 6 Avg. 2.3% 2.5% 1.5% Avg. 1.9% 2.6% 1.7% Avg. 2.2% 2.0% 1.7% AUD 4.5% 3.5% 1.7% AUD 0.5% NA 1.3% AUD 0.5% NA NA CAD 4.4% 3.2% 2.9% CAD 5.3% 4.4% 3.2% CAD 6.9% 3.1% 1.5% EUR -3.4% -2.5% -1.6% EUR -0.7% 0.1% 0.7% EUR -1.7% NA NA JPY 2.5% 11.3% 9.9% Threshold = 5% JPY 2.0% 7.6% 6.0% Threshold = 10% JPY 2.1% 0.9% NA NOK 0.2% NA NA NZD NA NA NA SEK NA NA NA CHF 1.4% 0.9% 1.4% US 6.1% 3.2% 2.1%
Source: J.P. Morgan
NOK -0.7% -2.1% -0.9% NOK -3.2% -1.6% -0.8%
NZD 6.2% 4.1% 1.8% NZD 1.5% 2.6% 2.0%
SEK 2.0% -0.3% 0.1% SEK 2.4% 0.4% -0.1%
CHF 2.2% 5.2% 0.1% CHF 2.4% 4.1% 1.7%
US 2.9% 0.4% -0.1% US 6.5% 3.2% 1.3%
Note: NA reflects situations when there were no trades for a particular currency and time horizon.
AUD-based investors and corporates The fair-value model also proved a reliable guide for AUDbased decision-makers. Table 8 shows that the signals are most reliable for a 6-month investment horizon, as in the cases of decisions where the USD and GBP are the base currencies. The strategy outperformed carry by over 2.5%
annualized, on average, over a 6-month investment horizon. Perhaps counter-intuitively and unlike the case of the USDbased decisions, higher action thresholds did not improve portfolio performance. And similar to the results for GBP-based investors and corporate hedgers, the deterioration of trading strategys performance at longer horizons is relatively small.
Table 8: AUD as base currency - profitability of fair value-based trading rules (% annual, net of carry), 2004-08
Threshold = 0% Horizon 2 4 6 Horizon 2 4 6 Horizon 2 4 6 Avg. 3.7% 2.4% 1.9% Avg. 2.4% 2.0% 1.5% Avg. 2.3% 1.9% NA CAD 1.9% -0.1% 0.1% CAD 1.9% 0.6% 0.4% CAD 3.4% 0.4% 0.7% EUR -0.9% 0.9% 1.2% EUR 0.7% 2.1% 1.5% EUR NA 0.5% 0.3% JPY 8.4% 6.4% 10.8% JPY 6.5% 7.1% 5.8% JPY 6.4% 3.8% 3.0% NOK -0.3% 0.9% 0.1% Threshold = 5% NOK -0.4% -0.1% 0.0% Threshold = 10% NOK 0.2% NA NA NZD 0.0% NA NA SEK 0.7% 1.1% 0.7% CHF 2.5% 3.0% 2.7% GBP 0.5% NA NA USD 4.5% 2.3% 1.7%
Source: J.P. Morgan
NZD 2.9% 0.3% -0.3% NZD 0.3% 0.3% 0.4%
SEK 5.6% 3.2% 1.9% SEK 3.2% 2.3% 1.6%
CHF 8.1% 7.4% 2.9% CHF 6.4% 5.0% 3.8%
GBP 4.5% 3.5% 1.7% GBP 0.5% NA 1.3%
USD 2.9% -0.4% -1.5% USD 2.4% -1.1% -1.4%
Note: NA reflects situations when there were no trades for a particular currency and time horizon.
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Global FX Strategy Managing FX hedge ratios May 26, 2010 Matthew Franklin-Lyons (1-212) 834 4565 matthew.d.franklin-lyons@jpmorgan.com JPMorgan Chase Bank NA
IV. Using alpha models to adjust hedge ratios tactically5

Dynamic hedging around a medium-term benchmark requires discretion or trading rules. The latter is tested in this section, building on two momentum models commonly used by currency overlay managers and global macro funds. Price momentum is the most basic trading strategy; it simply buys (sells) the best (worst) performing pairs. A rate momentum strategy, or forward carry, would buy currencies in whose favor interest rate expectations are moving. Standard industry models generate signals for two to four week horizons. Minor modifications, however, can generate signals of one to three months, which are more appropriate for hedge rebalancing. A price momentum model which adjusts dynamically around a 50/50 hedge ratio outperforms the benchmark by about 100bp annually, depending on the base currency. Information ratios on the strategy range from 0.2 to 0.5. A rate momentum (forward carry) model generates comparable outperformance but with more consistency across sample periods. Strategies are robust to various sample periods and model specifications.
Carry and momentum are the most commonly followed trading strategies across asset markets and in currencies. Momentum strategies are based on the empirical tendency of strong-performing assets to outperform again in the future, usually due to behavioural biases such as underreaction and overreaction.6 In FX, the standard momentum model trades in the direction of previous spot movements, as determined by a filter, moving average, or lookback rule. Despite the tendency to dismiss these frameworks as overly simplistic, the profits from such a strategy have been decent, at roughly 3.7% over the past ten years (table 1). Momentum strategies perform better in high-volatility environments but incur sizable drawdowns, and perform poorly in range bound environments or those exhibiting frequent reversals. Hence the poor performance of a basic momentum rule over the past year in which the dollar has experienced several sharp reversals (chart 1).
Chart 1: Returns on a simple price momentum rule since 2000 Indexed returns based on trading G-10 currencies versus USD. Trading rule uses 1-mo lookback for price momentum and daily rebalancing
180 170 160 150 140 130 120 110 100 90 00
Source: J.P. Morgan
Momentum only (9 USD pairs)
02
04
06
08
10
Alpha strategy basics

Short-term trading models, or alpha strategies, are employed extensively in currency overlay and global macro hedge fund communities to replicate the decision making process of investors. The approaches go by several names, such as systematic, tactical, short-term or alpha. We use the term alpha strategy since it conveys the underlying objective of outperforming a benchmark. Over the past decade J.P. Morgan has developed a suite of simple, intuitive trading rules to replicate common investment strategies across all major asset classes. The series of methodology notes entitled Investment Strategies is archived on www.morganmarkets.com.
The other standard alpha model is carry, which buys high yield currencies versus low-yield ones. This strategy has returned 4.2% per annum over the past decade, but given its high volatility (12%), its risk adjusted returns are the lowest of all alpha strategies we track (table 1). The very low frequency of signal changes a carry model would almost always be long AUD and short JPY also renders it in appropriate for dynamic hedging. An alternative to standard carry, which derives signals from the level of interest rate differentials, is forward carry,
6
This section amplifies models originally detailed in Alternatives to Standard Carry and Momentum in FX, Normand and Ghia, (2008).
22
Underreaction reflects investors inability or unwillingness to adjust views and positions quickly; either because they await fuller information to make a decision, or because they are reluctant to appear non-consensus. Accordingly, prices adjust slowly towards a markets fundamental value, in the process producing short-term trends. Overreaction is also based on cognitive biases. Although most investors adjust their expectations fully, some extrapolate this positive news into the future, thus leading prices to overshoot fundamental value.
which derives signals from changes in interest rate differentials. This strategy is based on the observation that currencies respond as much to spread changes as they do to spread levels. Low-yielding currencies can appreciate versus high-yielding currencies when rate spreads narrow in their favor, either because rates are falling more quickly in the high-yield country or rising more quickly in the lowyield country. For this reason, the forward carry framework proposes to position on changes in expected cash rate spreads rather than current cash rate differentials. This pattern is evident in both EUR/USD and USD/JPY in recent years (charts 2 and 3). In the case of EUR/USD, rate differentials as measured by the difference in Euro and US libor rates reliably signaled currency moves in the late 1990s and early 2000s. The euro depreciated when it yielded less than the dollar (1998 2000) and appreciated when it yielded more (2002 2004). This relationship between carry and EUR/USD has broken down since 20052008 when the euro rallied almost continuously despite a rate disadvantage to the US. In this case, the more significant driver has been the change in rate spreads: the euro rallied as the rate gap between the US and Europe narrowed, even though the dollar was the higher-yielding currency (chart 2). In USD/JPY as well, the mere existence of a US rate advantage over the yen has brought only limited spot appreciation (2000 02 and 2005 - 06). In many other periods, the change in rates has been more significant than the level of rates, as was the case in 2002 04 and in 2007 (chart 3). A simple strategy to exploit this phenomenon would buy the currency in whose favour interest rates are moving, regardless of whether it is a low or high-yielder. In essence, this strategy uses rate momentum as a signal for trading currencies. Over the past decade this strategy has returns 6% per annum on a volatility of 5% (table 1), so delivers performance with much less drawdown than most other alpha models (chart 4). Table 1 displays the historical performance of various alpha strategies and compares to those of currency managers and global macro hedge funds. Price momentum and forward carry (rate momentum) are the two we modify in this section for the purpose of a dynamic hedging model. Price momentum is tested since it is the simplest to construct; and forward carry because it has offered the best combination of performance and low volatility/drawdown. The original models were constructed to issue signals ever two to four weeks, consistent with the investment horizon of many tactical trading accounts. Minor modifications to the parameters generate signals for one to three month horizons, which is more consistent with the FX hedge rebalancing frequency of long-term investors and
Chart 2: EUR/USD versus Euro US rate expectations

rate expectations based on 1-mo rates 3-mos forward
300 200 100 0 -100 -200 -300 99

Source: J.P. Morgan
1.70 EU -US libor differential, bp EUR/USD 1.60 1.50 1.40 1.30 1.20 1.10 1.00 0.90 0.80 01 03 05 07 09
Chart 3: USD/JPY versus US Japan rate expectations

rate expectations based on 1-mo rates 3-mos forward
700 600 500 400 300 200 100 0 99
US-JA libor differential, bp USD/JPY
140 130 120 110 100 90 80
01
03
05
07
09
Source: J.P. Morgan
Chart 4: Forward carry performance since 2000 Based on G-10 currencies vs USD. Trading rule used 1mo rates 3mos forward, 1-mo lookback for rates and daily rebalancing
200 180 160 140 120 100 00 01 02 03 04 05 06 07 08 09 10 Forw ard Carry (9 USD pairs)
Source: J.P. Morgan
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corporates. As in Section III, all models are backtested against four base currencies: USD, EUR, GBP and AUD.
Modifying alpha strategies for dynamic hedging

The alpha signals have proven to be effective tools for positioning among currencies, and this section incorporates the strategies within dynamic hedging systems. Hedging decisions result in increased or decreased long exposure to one or more currencies, meaning that even default decisions to ascribe to a fixed coverage level implicitly results in foreign currency exposure. If systematic signals generated positive returns over time, then they should provide a useful guide to timing hedging decisions by signalling when, and in what direction to adjust coverage ratios. Before testing the efficacy of the signals, several adjustments to the basic strategies are necessary so as to make them relevant for medium-term hedgers. The original strategy backtests revealed that shorter lookback windows tend to generate the best results for forward carry signals. Since hedgers are unlikely to adjust their coverage at high frequencies, it is first necessary to extend the trading rules in such a way as to lengthen the holding period of the
trades. Both strategies, price momentum and forward carry, have two parameters in common which can be used to calibrate the signals to hedging behaviour: (1) the lookback period for measuring changes in price or rates; and (2) rebalancing frequency (daily, monthly). Various lookback windows impact returns and holding periods. A wide range of lookback windows are tested to identify strategies with appropriate holding periods, and positive returns. J.P. Morgans original models are rebalanced daily; but longer holding periods can also be imposed by restricting the rebalancing frequency. Signals are evaluated relative to a 50% hedged benchmark index. As discussed in Section II, no uniform hedge ratio applies to all investors or corporates, but a semi-hedged benchmark brings some advantages. Symmetric mandates allow the manager to be over or underhedged relative to the benchmark. Most select a 50% hedged benchmark for practical considerations, and anecdotal evidence confirms that this describes a fairly large cross-section of typical hedging behavior. For this reason, the following backtests use a 50% benchmark hedging index.
Table 1: Long-term performance of FX alpha strategies, currency managers and global macro funds
Alpha strategies Manager performance
G-10 carry (IncomeFX) 2010 YTD YTD return Std dev IR 2009 Avg annual return Std dev IR 2005 - 2009 (5 years) Avg annual return Std dev IR 2000 - 2009 (10 years) Avg annual return Std dev IR 9.0% 22.1% 0.41 4.8% 31.6% 0.15 57.9% 27.7% 2.09 -11.0% 18.7% -0.59
G-10 carry (unlevered)
Emerging Markets carry (IncomeEM)
Price momentum
Forward Carry Forward Carry (9 USD Pairs) (22 Major pairs)
Barclay HFR global Currency Barclay Group Parker macro hedge Traders Index BTOP FX Blacktree CMI funds
-7.0% 10.4% -0.67
-1.3% 19.2% -0.07
-5.6% 7.3% -0.77
7.7% 7.0% 1.11
2.1% 4.4% 0.48
1.1% NA NA
4.1% 3.9% 1.07
1.9% 3.1% 0.61
-0.8% 5.7% -0.13
20.6% 13.6% 1.51
10.2% 7.7% 1.34
-11.0% 12.0% -0.92
7.9% 8.6% 0.92
3.0% 5.6% 0.53
0.9% 1.5% 0.61
-2.9% 3.8% -0.76
-1.2% 2.8% -0.41
4.3% 6.3% 0.69
-0.1% 16.0% -0.01
7.3% 14.4% 0.51
-1.5% 8.7% -0.18
9.4% 3.6% 2.61
8.1% 6.1% 1.33
1.1% 1.9% 0.58
5.0% 12.4% 0.40
3.2% 3.0% 1.09
7.0% 2.7% 2.56
4.2% 12.1% 0.35
10.2% 16.2% 0.63
3.7% 8.9% 0.41
6.2% 5.2% 1.18
5.7% 5.1% 1.12
3.2% 3.5% 0.92
-7.0% 10.4% -0.67
-1.3% 19.2% -0.07
7.6% 6.1% 1.26
Source: J.P. Morgan
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From the perspective of a USD-based investor, alpha models are used to adjust hedge ratios as follows. Benchmark: 50% hedged, 50% unhedged Signal based strategy: Long USD signal: 75% hedged, 25% unhedged Short USD signal: 25% hedged, 75% unhedged If the model issues a buy signal on the dollar, the hedge ratio is increased to 75% to capture the expected depreciation of the foreign currency. If a sell USD signal is issued, the hedge ratio is reduced to 25% to profit from expected foreign currency strength. These +/-25% fluctuation bands are chosen for simplicity but are consistent with anecdotally-acceptable hedge ratios. Backtests are conducted using J.P. Morgan Index Researchs hedged and unhedged bond indices7 which hedge monthly via forward contracts and rebalance at the close of the first business day of the month. The percentage of the portfolio is chosen according to the benchmark specification (50%), or as indicated by a given signal. Results are generated across G-10 pairs, from the standpoint of USD based investors, GBP based investors, and AUD based investors hedging G-10 pairs back to their respective home currencies in each case. 8 The full set of results include backtests across a wide range of strategy specifications, across G-10 currencies, and two sample periods (past five and ten years). Given these permutations, complete results are confined to the Appendix. The backtests focus on the two most simple strategy building blocks, simple momentum and forward carry. Forward carry is tested using lookback windows of 20, 40, 60, 100 and 120 business days. Price momentum is tested on lookback windows of 20, 40, 100, 200 and 252 business days. Both strategies are also tested with and without restrictions on a fixed rebalancing day at month-end. All strategies are assessed for the excess return (outperformance) versus the 50/50 benchmark, the volatility of that outperformance (tracking error) and their information ratio (excess return divided by volatility of excess return). Performance tables also display averages
The hedging simulation relies on the JPMorgan hedged and unhedged bond indices across G10 currencies with the exception of NOK and CHF, which are Bloomberg government bond indices. Please see JPMorgan Government Bond Indices, Francis Diamond (2002). 8 These base currencies were chosen to highlight performance across three economically diverse regions, with highly different exchange rate behavior.
7
across all of the individual currency results for a given strategy. This provides an overview which helps to gauge the general performance of a given strategy across all of the currencies.
Results: Price momentum

The simple momentum results are displayed within tables 2 and 3. This strategy generates significant and consistently positive excess returns across currencies, sample periods and model specifications. For example, in the case of a 100 or 40-day lookback windows, the strategy generated an average excess performance of around 2% over 10 years resulting in an average information ratio of around 0.7, and was profitable across 100% of the 9 major G10 pairs (table 2). Not surprisingly, the average holding periods for the strategies are dependent on the lookback window chosen. For example, 20 to 40-day lookback windows generate holding periods of around one month, 100-day lookbacks generate holding periods of about two months, and longer (200 to 252-day) lookback windows generate holding periods of three to four months. In the aggregate, it appears that price momentum tends to favor shorter lookback windows over the past decade. These cross currency averages mask fairly significant intracurrency details. Table 3 displays the results for only the 40-day lookback window. As already indicated in table 2, the strategy is profitable across all G-10 pairs, over both time periods. The best performances over a ten-year sample are AUD, NZD, CAD, and EUR. The appendix tables replicate the analysis across three additional base currencies (GBP, EUR, and AUD) and the full range of lookback windows. These results are broadly consistent with that of the USD based strategies as most lookback windows are profitable across most G10 pairs. The EUR strategies are the worst performing, with average annual performance of only 0.5% above that of the benchmark strategy in most cases (appendix table 1). GBP based backtests are more successful, with average annual excess returns of around 1% for 40 to 100-day lookback windows using ten years of data (appendix table 3). Finally, the AUD based results have positive excess returns, with the best performances for shorter lookback windows where average annual returns are 1-3% above that of the benchmark index, resulting in information ratios of around 0.4 to 0.8 over the past decade (appendix table 5).
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Table 2: Dynamic hedging with a price momentum signal: performance of G-10 currencies with USD as the base Excess returns over the 50/50 benchmark. Table entries are averages of results across all G-10 USD pairs
252 Day 1.3% 3.0% 0.44 100% 252 Day -0.1% 2.7% -0.12 44% 52 4 200 Day 1.7% 3.1% 0.57 86% 200 Day 0.9% 2.9% 0.29 89% 63 3 100 Day 2.0% 3.2% 0.65 100% 100 Day 2.2% 3.0% 0.87 100% 97 2 40 Day 2.2% 3.1% 0.73 100% 40 Day 1.7% 3.6% 0.51 100% 172 1 20 Day 2.7% 2.7% 1.01 100% 20 Day 2.1% 3.0% 0.84 89% 256 1
2000 - 2009 (10 years) Avg annual return Std dev IR %ccy with profitable strategies 2005 - 2009 (5 years) Avg annual return Std dev IR %ccy with profitable strategies # of trades* average months per trade* *Using 10y or maximum available history
Source: J.P. Morgan
Table 3: Individual currency excess returns of price momentum rule-based index versus benchmark index: 9 USD pairs Excess returns over the 50/50 benchmark.
40 bus. day lookback window USD/CAD 2000 - 2009 (10 years) Avg annual return Std dev IR 2005 - 2009 (5 years) Avg annual return Std dev IR # of trades* average months per trade* *Using 10y or maximum available history 2.4% 2% 1.25 170 1 1.2% 3% 0.42 140 1 1.9% 4% 0.43 196 1 1.0% 3.5% 0.28 189 1 1.3% 4.0% 0.32 192 1 0.2% 2% 0.10 140 1 2.9% 6.7% 0.43 163 1 2.0% 3.2% 0.60 180 1 2.8% 3.8% 0.74 181 1 2.4% 2% 1.18 2.1% 2% 0.83 NA NA NA 1.2% 2.5% 0.49 2.0% 3.2% 0.62 NA NA NA 3.3% 5.0% 0.66 1.1% 2.9% 0.36 3.7% 3.8% 0.96 USD/EUR USD/NOK USD/GBP USD/SEK USD/CHF USD/AUD USD/JPY USD/NZD
Source: J.P. Morgan
Results: Forward carry

Forward carry results are displayed within Table 4 and Table 5. As before, the strategies generate decent excess returns across currencies, sample periods and model specifications. Forward carry tends to favor 60 to 100-day lookback windows, delivering excess returns of 1-2% per annum. For example, in the case of 60-day lookback, the strategy generated an average excess performance of 1.5% over ten years, 2.2% over five years, and was profitably over all currencies over both periods (table 4). For medium-term lookbacks (40 to 100-day), information ratios ranged from 0.3 to 0.9. As before, the average holding period is longer for longer lookback windows, with average
trades of one month for shorter windows, and as long as three months for the longest lookback (120-day). Table 5 displays the individual currency results for a 60-day lookback. This strategy performs well across most currencies, and has been best for AUD, NZD, CAD and GBP. Holding periods are in the one to two month range depending on the lookback. All of these results appear well suited for dynamic hedging where investors or corporates rebalance on a one to three month horizon. The appendix also presents results for the other base currencies of EUR, GBP and AUD. The results are consistent with that of the USD-based strategies. The EUR results are good, with average annual excess returns of 0.6% to 0.8% (appendix table 2). GBP-based strategies result in excess performance of around 1% and IRs of 0.3 to 0.4 over
26
shorter lookbacks (20 to 60-day), as shown in appendix table 4. Finally, the AUD based results have positive annual excess returns, with the best performance for shorter lookback windows where average annual returns are around 1%, resulting in information ratios of around 0.3 to 0.5 (appendix Table 6).
Chart 5: Cash flows on CAD hedged into USD based on 60-day forward carry signal
Cumulative and monthly cash flows
10% 8% 6% 4% 2% 0% -2% -4% -6% 00 01 02
Monthly Signal CF, lhs Cumulativ e Benchmark CF, rhs Cumulativ e Signal CF, rhs
30% 20% 10% 0% -10% -20% -30%
Cash flow analysis

Excess returns from these signaling models can also be illustrated through cash flows. Charts 5 through 7 display the monthly returns of the signal based index, and the cumulative monthly returns of the signal based index and the benchmark index from a USD perspective against CAD, from a GBP perspective against USD, and from an AUD perspective against USD. In cases where the alpha strategy signals generate excess returns over the benchmark, the strategys cumulative cash flows will be greater than that of the benchmark strategy. In each of these cases, the signal based strategy is able to outperform the benchmark index consistently.
03
04
05
06
07
08
09
10
Source: J.P. Morgan
Robustness tests: month-end restrictions

Tables 6 and 7 display the results of the simple momentum and forward carry strategies respectively, both with rebalancing restricted to the month-end. The month-end restriction has a significant impact on performance in most cases, but performance remains positive across G-10 pairs. Additionally, adding month-end restrictions greatly increases the holding period of the trades across all strategies. This is of course not surprising, since the monthly restriction is essentially a lower bound on the number of trades that can be taken. In the case of price momentum, (table 6) it appears that profitability is preserved under the restricted strategy. A shorter lookback window provides consistently positive performance across the G10. The dramatic effect of the month-end restriction on holding periods is also apparent: even in the case of shorter lookback windows, most holding periods are in the range of three or four months. The month-end restriction results in profitable average annual returns in the case of forward carry as well (table 7). Medium (40-100d lookback windows) are able to generate 1% of excess returns versus the benchmark on average. Interestingly, for certain lookback windows, the monthly rebalancing restriction actually increases returns, although this is likely an aberration.
Chart 6: Cash flows on USD hedged into GBP based on 60-day forward carry signal Cumulative and monthly cash flows
10% Monthly Signal CF, lhs Cumulativ e Benchmark CF, rhs Cumulativ e Signal CF, rhs 30%
5%
20%
0%
10%
-5%
0%
-10% 00 01 02 03 04 05 06 07 08 09 10
-10%
Source: J.P. Morgan
Chart 7: Cash flows on USD hedged into AUD based on 60-day forward carry signal
Cumulative and monthly cash flows
10%
Monthly Signal CF, lhs Cumulativ e Benchmark CF, rhs Cumulativ e Signal CF, rhs
40% 30% 20% 10% 0% -10% -20%
5%
0%
-5%
-10% 00 01 02 03 04 05 06 07 08 09 10
-30%
Source: J.P. Morgan
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Table 4: Dynamic hedging with forward carry signal: performance of G-10 pairs with USD as the base currency Excess returns over the 50/50 benchmark. Table entries are averages of results across all G-10 USD pairs
120 Day 0.9% 2.9% 0.29 71% 120 Day 1.6% 2.8% 0.56 100% 55 3 100 Day 1.1% 3.1% 0.32 100% 100 Day 1.9% 3.1% 0.64 100% 60 3 60 Day 1.5% 3.3% 0.50 100% 60 Day 2.2% 3.3% 0.82 100% 98 2 40 Day 1.5% 2.9% 0.60 86% 40 Day 1.9% 2.6% 0.89 100% 136 1 20 Day 1.9% 2.2% 1.13 100% 221 1 20 Day 1.3% 2.6% 0.55 86%
Source: J.P. Morgan
Table 5: Individual currency performance with forward carry signal with USD as the base currency
60 bus. day lookback window USD/CAD 2000 - 2009 (10 years) Avg annual return Std dev IR 2005 - 2009 (5 years) Avg annual return Std dev IR # of trades* average months per trade* *Uses 10y or maximum available data period 1.7% 2.7% 0.62 88 2 1.7% 1.4% 1.25 130 1 2.4% 1.7% 1.37 82 2 1.1% 5.5% 0.19 80 2 1.6% 3.6% 0.44 93 2 2.1% 2.3% 0.94 101 2 2.2% 5.4% 0.41 144 1 2.6% 3.7% 0.69 74 2 4.3% 3.0% 1.44 90 2 1.7% 1.9% 0.86 0.6% 1.8% 0.32 NA NA NA 1.3% 4.2% 0.32 0.7% 3.4% 0.19 NA NA NA 1.3% 4.9% 0.27 0.6% 3.5% 0.17 4.3% 3.2% 1.37 USD/EUR USD/NOK USD/GBP USD/SEK USD/CHF USD/AUD USD/JPY USD/NZD
Source: J.P. Morgan
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Table 6: Performance of price momentum signal with month-end restriction and USD as base currency Excess returns over 50/50 benchmark
Source: J.P. Morgan
Table 7: Performance of forward carry signal with month-end restriction and USD as base currency Excess returns over 50/50 benchmark
120 Day 0.9% 3.1% 0.26 71% 120 Day 1.6% 2.9% 0.60 100% 12 15 100 Day 0.9% 2.9% 0.31 86% 100 Day 1.9% 3.1% 0.64 100% 13 13 60 Day 1.8% 3.0% 0.63 100% 20 9 60 Day 0.9% 3.1% 0.27 86% 40 Day 1.3% 2.9% 0.45 71% 40 Day 1.6% 2.6% 0.74 89% 31 5 20 Day 0.9% 2.7% 0.36 89% 22 9 20 Day 0.8% 2.8% 0.26 71%
Source: J.P. Morgan
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Appendix charts: Excess returns for price momentum and forward carry signal with EUR, GBP and AUD as the base currency. Table 1: EUR as base currency performance of price momentum signal Excess returns over the 50/50 benchmark. Table entries are averages of results across all G-10 EUR crosses.
252 Day 0.2% 2.5% 0.08 71% 252 Day 0.0% 2.7% -0.06 56% 91 2 200 Day 0.5% 2.5% 0.20 86% 200 Day 0.2% 2.6% 0.03 67% 93 2 100 Day 0.5% 2.3% 0.21 86% 100 Day 0.5% 2.3% 0.26 67% 128 2 40 Day 0.4% 2.5% 0.13 71% 40 Day 0.3% 2.8% 0.04 44% 204 1 20 Day 0.6% 2.6% -0.04 67% 275 1 20 Day 0.9% 2.4% 0.35 71%
Source: J.P. Morgan
Table 2: EUR as base currency performance of forward carry signal Excess returns over the 50/50 benchmark. Table entries are averages of results across all G-10 EUR crosses.
120 Day 0.5% 2.5% 0.17 71% 120 Day 1.1% 2.5% 0.42 100% 77 2 100 Day 0.7% 2.6% 0.24 86% 100 Day 1.4% 2.6% 0.50 100% 87 2 60 Day 1.0% 2.3% 0.46 100% 131 1 60 Day 0.6% 2.5% 0.28 57% 40 Day 0.7% 2.4% 0.31 71% 40 Day 0.6% 2.2% 0.28 67% 172 1 20 Day 1.0% 2.4% 0.52 100% 236 1 20 Day 0.8% 2.4% 0.32 86%
Source: J.P. Morgan
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Table 3: GBP as base currency performance of price momentum signal Excess returns over the 50/50 benchmark. Table entries are averages of results across all G-10 GBP crosses.
252 Day 0.6% 3.2% 0.18 86% 252 Day 1.0% 3.6% 0.33 78% 68 3 200 Day 0.7% 3.1% 0.18 71% 200 Day 0.8% 3.9% 0.23 78% 94 2 100 Day 1.0% 3.1% 0.38 100% 100 Day 1.5% 3.4% 0.52 89% 130 1 40 Day 0.5% 3.3% 0.14 71% 40 Day 0.8% 4.1% 0.06 78% 204 1 20 Day 1.2% 2.8% 0.52 100% 20 Day 1.3% 2.9% 0.47 89% 272 1
Source: J.P. Morgan
Table 4: GBP as base currency performance of forward carry signal Excess returns over the 50/50 benchmark. Table entries are averages of results across all G-10 GBP crosses.
120 Day 0.4% 2.6% 0.07 71% 120 Day 0.8% 3.1% 0.29 89% 79 2 100 Day 0.8% 3.1% 0.25 86% 100 Day 1.3% 3.9% 0.34 89% 94 2 60 Day 1.1% 3.5% 0.27 100% 60 Day 1.3% 4.1% 0.31 100% 122 1 40 Day 1.0% 3.2% 0.32 100% 40 Day 1.0% 3.2% 0.28 78% 156 1 20 Day 1.1% 2.7% 0.64 89% 244 1 20 Day 1.1% 2.8% 0.38 86%
Source: J.P. Morgan
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Table 5: AUD as base currency performance of price momentum signal Excess returns over the 50/50 benchmark. Table entries are averages of results across all G-10 AUD crosses.
Source: J.P. Morgan
Table 6: AUD as base currency performance of forward carry signal Excess returns over the 50/50 benchmark. Table entries are averages of results across all G-10 AUD crosses.
120 Day 0.8% 3.6% 0.27 67% 120 Day 1.7% 3.8% 0.26 83% 60 3 100 Day 1.2% 3.6% 0.36 100% 100 Day 2.4% 4.0% 0.67 100% 65 3 60 Day 1.8% 4.1% 0.43 100% 113 1 60 Day 0.9% 3.6% 0.30 83% 40 Day 1.1% 3.3% 0.38 100% 40 Day 1.2% 3.7% 0.30 83% 140 1 20 Day 1.2% 3.3% 0.45 100% 20 Day 1.4% 3.7% 0.60 100% 226 1
2000 - 2009 (10 years) Avg annual return Std dev IR %ccy with profitable strategies 2005 - 2009 (5 years) Avg annual return Std dev IR %ccy with profitable strategies # of trades** average months per trade** *Using 10y or maximum available history
Source: J.P. Morgan
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Global FX Strategy Managing FX hedge ratios May 26, 2010 Arindam Sandilya (1-212) 834-2304 arindam.x.sandilya@jpmchase.com JPMorgan Chase Bank NA
V. Hedging with forwards versus options

Compared to extensive studies on forwards-based hedging, work on options approaches is limited. This section compares the returns of a forward versus option strategy in hedging a portfolio employing a 50/50 hedge ratio. For AUD, EUR and GBP based investors with USD exposure, hedging with options has outperformed forwards since 2003. From a corporate perspective, options outperformed for long USD/short AUD, EUR and GBP exposure. A signalling model which switches between forwards and options does not provide substantial advantage over an outright option based hedge. This conclusion is sensitive to methodology, however.
mimicking the base case forward hedge. For ATM options with delta of approximately 50, this means buying 100 units notional of foreign currency puts. The 50% hedge ratio holds true only at inception, however. Unlike forwards that offer a constant coverage ratio, option deltas fluctuate with moves in spot, interest rates, volatility and the passage of time, causing the hedge ratio to vary between the upper and lower delta thresholds of 0% and 100%. Thus market moves alone can leave investors either under- or over-hedged relative to the forward hedge benchmark, an unavoidable consequence of this approach. An alternative uses the same notional of options as the notional of the benchmark forward hedge in this example, 50 units of the foreign currency. But given that option deltas vary between 0 and 1, the directional exposure from an ATM option sized according to this scheme can range between 0 to 50 foreign currency units, or a hedge ratio range of 0% - 50% on the total FX risk of 100 units. This approach renders a portfolio with a (foreign currency) put option overlay systematically under-hedged vis--vis one with a short (foreign currency) forward overlay, which may not be desirable. For consistency with Section IV of this paper we prefer the former scheme, but the second option using equivalent notionals will be worth exploring in forthcoming research. The sample period for the study is 2003 to the present, reflecting the availability of options data. The universe of option hedges examined is limited to 1-mo vanillas, and to only the two structures most commonly used for hedging purposes: straight ATM puts on the foreign currency, and 10D, 25D and 40D risk reversals (long foreign currency puts versus short foreign currency calls). The analysis contains one important simplification relative to the previous section. The notional size of the forward hedges considered in Section IV is an estimate of the expected value of the core asset holdings (e.g. JPMorgan bond indices). Because the purpose of this section is to compare the efficacy of two hedging instruments, we hold the notional of foreign currency exposure constant here, thereby avoiding the influence of moves in core holdings on the results. The study assumes that non-US investors hold $100 of US assets, whose value fluctuates solely due to variations in the local currency/USD exchange rate. Chart 1 depicts the hedged and unhedged returns from the perspective of AUD, EUR and GBP- based investors, and Table 1 details the performance of the various hedging strategies. From a corporate perspective, the company is long USD and short AUD, EUR and GBP. Note that the results in the table hold only for US investments by foreign investors, unlike Sections II IV of this paper which presented results across a broader range of base currencies and related crossrates.
FX hedging analysis is typically conducted based on forwards rather than options. For completeness, options should also be considered. Although there exist many empirical studies on forward contracts to hedge currency risk, the literature on derivatives-based hedging is relatively light. The primary difference between the two instruments is options non-linear payoff which leads to complex, distinctly asymmetric return distributions. Of course, the non-linearity of payoffs comes at a cost the option premium which can be a disincentive for some hedgers given the zero upfront cost of forwards. Option premia can, however, be higher or lower than the subsequent delivered performance; it is not immediately clear a priori if the necessity of an upfront cash payment in itself impairs the effectiveness of these instruments. This section backtests a series of option-based alternatives to forward hedges since 2003. We also test the efficacy of a switching rule which positions in either forwards or options depending upon the conviction of the signal in forecasting a spot trend.
Base case: replicating a 50/50 hedge ratio

This analysis assumes a base case forward hedge for benchmarking the performance of option hedges. As before, this is taken to be 50% of the total currency risk hedged using 1-mo forwards: the benchmark hedge for 100 units of foreign currency exposure is to sell 50 units of it forward. It is trickier to compute the equivalent notional of options required to perform an apples-to-apples study. A theoretically appropriate way to proceed would back out a notional number that leaves the option-hedged foreign currency risk at 50% of the original exposure, exactly
34
The narrower sample here reflects the microstructure of FX option markets options on crosses are less liquid than those in the USD majors. This means that while notional size is not an issue for AUD-based investors hedging European or UK assets through forwards, deploying EUR/AUD or GBP/AUD puts as hedges runs into notional constraints. Given this liquidity issue, options performance is shown for USD-pairs only.
Results: forwards versus options

The charts and table highlight the following: Given the dollars general downtrend against most currencies over the sample, period, hedging currency exposure on US assets has tended to be profitable. ATM options sized to provide the same hedge ratio as the benchmark forward hedge at inception generally dominate forwards as hedge instruments, more in AUD than in EUR or GBP. This pattern is largely attributable to the direction of the underlying spot rates over the backtest period. With dollar weakness prevailing for most of the last seven years, USD put/local currency call options spent the majority of their lives in the money, and effective hedge ratios offered by options were generally greater than the 50% provided by the benchmark forward hedge. In other words, options generally overhedged investors relative to the benchmark, which turned out to be quite profitable in a declining dollar environment. In option parlance, ATM foreign currency puts possess favorable dHedgeRatio/dSpot properties: the effective notional of the hedge increases precisely when needed during periods of a declining foreign currency. This convexity of course comes at a price in the form of paying away premium for put options that expire worthless in periods of strengthening foreign currency. EUR and GBP have encountered steeper and more extended spot declines against USD than AUD over the past six months, and ATM USD puts/currency calls therefore have given back a large part of their outperformance relative to forwards over this period. Risk reversals perform better in EUR and GBP than in AUD. Intuitively, risk reversals should track the forward hedge, given their similarity to a forward in being exposed to both appreciation and depreciation of in the underlying exchange rate. (Thus symmetry becomes clearer if one thinks of a forward as the combination of a call and a put, both struck at the forward; a risk reversal can be created by simply pulling the call and strikes away from the forward strike in opposite directions). The more
out-of-the-money the two strikes, the more obvious the delinkling from the performance of forwards. 10D risk reversals exhibit interesting behavior in that selling wing USD calls for a leveraged notional was a painful experience during the credit crisis as vols and skews blew out, thus detracting from hedge performance relative to forwards. This phenomenon was especially pronounced in AUD, where the penalty was substantially higher than in most currencies.
Table 1. Option-based hedges (ATM puts or risk reversals) have outperformed forwards and a rule-based switching strategy between forwards and options.
Assumes USD exposure of $100 for all local currencies. Benchmark hedge is a 50% short foreign currency forward. Option hedges are sized to provide the same hedge ratio as the benchmark forward hedge at inception. No transaction costs
Local Currency
Strategy Unhedged Hedged v ia Forw ard Hedged v ia Option Hedged v ia 40dRiskRev ersal Hedged v ia 25dRiskRev ersal Hedged v ia 10dRiskRev ersal Hedged v ia Signal (option and fw d) Hedged v ia Signal (25d rr and fw d) Unhedged Hedged v ia Forw ard Hedged v ia Option Hedged v ia 40dRiskRev ersal Hedged v ia 25dRiskRev ersal Hedged v ia 10dRiskRev ersal Hedged v ia Signal (option and fw d) Hedged v ia Signal (25d rr and fw d) Unhedged Hedged v ia Forw ard Hedged v ia Option Hedged v ia 40dRiskRev ersal Hedged v ia 25dRiskRev ersal Hedged v ia 10dRiskRev ersal Hedged v ia Signal (option and fw d) Hedged v ia Signal (25d rr and fw d)
Average Return -6.5% -1.8% 0.1% -1.5% -1.7% -6.4% -0.6% -1.8% -3.1% -1.6% -1.5% -1.4% -1.2% -2.6% -1.5% -1.6% 0.7% 0.9% 1.0% 1.0% 1.0% 0.5% 0.8% 1.1%
Volatility 15.2% 6.3% 7.8% 5.9% 5.8% 13.4% 8.2% 5.9% 10.1% 4.6% 5.5% 4.6% 4.8% 6.7% 5.6% 4.8% 10.5% 5.0% 6.2% 5.1% 5.6% 8.6% 5.9% 5.5%
IR -0.43 -0.28 0.01 -0.26 -0.29 -0.48 -0.08 -0.30 -0.31 -0.35 -0.28 -0.30 -0.24 -0.38 -0.28 -0.33 0.07 0.18 0.15 0.19 0.18 0.06 0.13 0.19
AUD
EUR
GBP
Source: J.P. Morgan
Results: a signalling model for switching between forwards and options

Table 1 also lists the performance of a signal-based hedging strategy that switches between a forward and an equivalent delta option or a risk reversal depending on the conviction from the alpha models described in
35
Section IV. A buy or sell signal from the models represents a high-conviction view on spots direction, so would justify hedging with forwards. A neutral reading from the models represents a low-conviction view, so would justify hedging with options instead. The strategies information ratios defined as outperformance versus benchmark divided by the volatility of outperformance indicate that while the switching rule applied either to an ATM put or a risk-reversal outperforms forward hedges in most cases, the magnitude is small. An outright option-based hedging strategy has delivered better performance for all currencies, although this conclusion could be sensitive to sample period and baseline hedge ratio chosen (50/50 benchmark versus a neutral of either zero or 100% hedging). For instance, AUD-based investors actually increase the volatility of their hedged portfolio by switching between forwards and options (8.2%) as opposed to hedging purely with options (7.8%), even as the returns from doing so are lower (-0.6% with forwards plus options versus 0.1% with options alone). This pattern probably owes to the filter rule. While correct more than 50% of the time in identifying the appropriate spot environments for switching into options, the rule does not incorporate rich/cheap considerations in option prices as an input, which is a critical consideration for most investors. The delta-adjusted methodology probably also shapes the outcome. By allowing the option to have a notional twice as large as the forward contract, a simple directional signal which does not take into account the expected extent of spots upward or downward movement becomes difficult to apply. A more neutral framework to assess the signals value would maintain the same notional of the two hedging instruments. This issue can be addressed in subsequent research.
36
Chart 1. Hedging USD exposure has been prudent AUD, EUR, and GBP- based investors since 2003, and ATM options have performed at par or better than forwards.
Assumes core USD exposure of $100 for all local currencies. Benchmark hedge is a 50% short foreign currency forward. Option hedges are sized to provide the same hedge ratio as the benchmark forward hedge at inception. No transaction costs
AUD/USD
250
200
Unhedged Fw d Hedged ATM Option Hedged
180 160 140
200
150
120
100 Jan-03
Source: J.P. Morgan
40D RR Hedged 25D RR Hedged 10D RR Hedged Jun-04 Dec-05 Jun-07 Nov -08 May -10
100
Jun-04 Dec-05 Jun-07 Nov -08 May -10
Jan-03
Source: J.P. Morgan
EUR/USD
100 100 95 90 90 85 80 75 Unhedged Fw d Hedged ATM Option Hedged Jun-04 Dec-05 Jun-07 Nov -08 May -10 70 65 Jan-03 Jun-04 Dec-05 Jun-07 Nov -08 May -10 40D RR Hedged 25D RR Hedged 10D RR Hedged
80
70
60 Jan-03
Source: J.P. Morgan
Source: J.P. Morgan
GBP/USD
80 75 70 65 60 55 50 45 Jan-03
Source: J.P. Morgan
75
Unhedged Fw d Hedged ATM Option Hedged
70 65 60 55 50 45
40D RR Hedged 25D RR Hedged 10D RR Hedged
Jun-04
Dec-05
Jun-07
Nov -08
May -10
Jan-03
Jun-04
Dec-05
Jun-07
Nov -08
May -10
Source: J.P. Morgan
37
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J.P. Morgan Global FX Strategy

London
John Normand Paul Meggyesi Thomas Anthonj Kamal Sharma Talis Bauer MD MD ED VP VP Head, Global FX Strategy G-10 FX Strategy Technical Strategy G-10 FX Strategy FX Derivatives Strategy (44-20) 7325-5222 (44-20) 7859-6714 (44-20) 7742-7850 (44-20) 7777-1729 (44-20) 7777-5276 john.normand@jpmorgan.com paul.meggyesi@jpmorgan.com thomas.e.anthonj@jpmorgan.com kamal.x.sharma@jpmorgan.com talis.s.bauer@jpmorgan.com
New York
Ken Landon Gabriel de Kock Niall OConnor Arindam Sandilya Matthew Franklin-Lyons MD ED ED ED Analyst G-10 FX Strategy G-10 FX Strategy Technical Strategy FX Derivatives Strategy G-10 FX Strategy (1-212) 834-2391 (1-212) 834-4254 (1-212) 834-5108 (1-212) 834-2304 (1-212) 834-4565 kenneth.landon@jpmorgan.com gabriel.s.de.kock@jpmorgan.com niall.oconnor@jpmorgan.com arindam.x.sandilya@jpmorgan.com matthew.d.franklin-lyons@jpmorgan.com
Asia
Tohru Sasaki Junya Tanase Yen Ping Ho Yoonyi Kim MD ED VP (Emerging Markets Research) Analyst G-10 FX Strategy G-10 FX Strategy Asia FX Strategy G-10 FX Strategy (81-3) 6736-7717 (81-3) 6736-7718 (65) 6882-2216 (81-3) 67367729 tohru.sasaki@jpmorgan.com junya.tanase@jpmorgan.com yenping.ho@jpmorgan.com yoonyi.x.kim@jpmorgan.com
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JP Morgan - Managing FX Hedge Ratios - A Framework For Strategic and Tactical Decisions

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Global FX Strategy

May 26, 2010

Managing FX hedge ratios

I. Overview: Four common questions on hedging policy

II. The merits of long-term FX exposure2

Chart 4: Bond returns hedged vs unhedged into USD, 1988-2009

0% USD JPY EUR GBP AUD CAD GBI ex US

Chart 2: Equity volatility hedged vs unhedged into USD, 1988-2009

Chart 5: Bond volatility hedged vs unhedged into USD, 1988-2009

0% USD JPY EUR GBP AUD CAD MSCI exUS

Source: J.P. Morgan

Chart 3: Equities for USD-based investors: return vs risk, 1988 - 2009

Chart 6: Bonds for USD-based investors: return vs risk, 19882009

10 US equities 5 World ex US, hedged 5 10 15 20 25 Risk, %

World ex US, unhedged

Source: J.P. Morgan

Source: J.P. Morgan

Three exceptions: emerging markets, catastrophe insurance and portfolio diversifier

Exception 1: emerging markets as a source of long-term returns

Exception 3: FX exposure may reduce portfolio risk

17% 15% 4% -5% -7% 6%

Source: J.P. Morgan

Chart 8: Emerging markets FX Sharpe ratios, 1994-2009

Source: J.P. Morgan

Exception 2: catastrophe insurance and asset/liability matching require unhedged FX exposure

breakeven FX/asset correlation

Chart 9: Threshold correlation for portfolio risk reduction

percent allocation to foreign equities

Source: J.P. Morgan

Source: J.P. Morgan

Source: J.P. Morgan

The optimal hedge ratio: no size fits all

Source: J.P. Morgan

Chart 15: Performance with and without overlay

symmetric hedge + overlay

50/50 hedge ratio as policy of least regret

Chart 3: Bond returns hedged vs unhedged into EUR, 1993-2009

Chart 2: Equity volatility hedged vs unhedged into EUR, 1989-2009

Chart 4: Bond volatility hedged vs unhedged into EUR, 1993-2009

Chart 3:Equities for EUR-based investors: return vs risk, 1988 2009

Chart 6: Bonds for EUR-based investors: return vs risk, 1993 - 2009

Source: J.P. Morgan

Chart 4: Bonds hedged vs unhedged into GBP, 1993-2009

Chart 2: Equity volatility hedged vs unhedged into GBP, 1988-2009

Chart 5: Bond volatility hedged vs unhedged into GBP, 1993-2009

15% 10% 5% 0% GBP

Chart 3: Equities for GBP-based investors: return vs risk, 1988 - 2009

Chart 6: Bonds for GBP-based investors: return vs risk, 1993 - 2009

UK bonds World ex UK, unhedged

World ex UK, unhedged World ex UK, hedged

World ex UK, hedged

Source: J.P. Morgan

Source: J.P. Morgan

Chart 4: Bonds hedged vs unhedged into AUD, 1993-2009

Chart 2: Equity volatility hedged vs unhedged into AUD, 1988-2009

Chart 5: Bond volatility hedged vs unhedged into AUD, 1993-2009

Chart 3: Equities for AUD-based investors: return vs risk, 1988 - 2009

Chart 6: Bonds for AUD-based investors: return vs risk, 1988 - 2009

World, hedged World, unhedged -

Source: J.P. Morgan

Source: J.P. Morgan

Source: J.P. Morgan