The FX Hedge Efficiency Score

A Universal Measure of Performance By Jay Moore, CFA

The effectiveness of an FX hedge has long been without a standard method of measurement. A lack of a universal measure deprives both investment managers and their end investors of a meaningful way to evaluate performance and understand the effectiveness of their process. Consequently, the absence of a comparison prevents a manager from demonstrating achieve- ment of their investment objectives. That is about to change.

Brown Brothers Harriman has developed a simple metric that distills the effectiveness of an FX hedging program into a single score allowing comparison across funds, managers or service providers -- the FX Hedge Efficiency Score.

The FX Hedge Efficiency Score provides investors with an effective comparison of hedging programs. Most importantly, it creates a basis upon which more detailed conversations around the calibration of the hedging program can take place. It provides insight into target areas of improvement and whether those improvements may relate to timing, costs and/or operational workflows.

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INVESTOR SERVICES Foreign Exchange Key Assumptions: For example, if a USD (local) asset returned 10.00% over a given 1. The hedging program is designed to recover as much of the period and the unhedged return of that asset to a GBP based FX spot effect as possible. The spot effect is defined as the investor over the same period was 5.00%, the spot effect is effect of FX from translating an investment from its value equal to -5.00%. In other words, the US Dollar depreciated by in foreign currency (local) terms to its value in investor cur- 5.00% relative to the British Pound. rency terms (unhedged). The intention is not to enhance returns through active management of FX, but to minimize Next, the performance difference between the hedged and local FX exposure. returns attributable to the interest rate differential (IRD) between the two currencies over the hedge period must be accounted for. 2. The goal is to achieve the above with as much certainty and To do this, we need to adjust the hedged performance up or down consistency (minimal tracking error) as possible. to account for the difference in cross border risk free interest rates. In our example, we assume an IRD for the period of 0.50%, The FX Hedge Efficiency Score is designed to assess these two meaning that risk free rates in the UK are 0.50% higher than in key elements of performance: spot recovery (return) and track- the US. This should yield a perfectly hedged return of 10.50% for ing error elimination (risk). GBP based investors in the absence of all other implementation factors. Such factors might include timing delays, costs, unreal- Spot Recovery Ratio ized P&L of the hedge or the fact that the hedge is a reaction to past information (asset value uncertainty). The goal of the hedge is to recover/offset the greatest percent- age of the FX spot effect as possible. The FX spot effect repre- We can now measure the “spot recovery” reflected in the sents the return element of the FX Hedge Efficiency Score and hedged performance by comparing the adjusted hedged return is calculated (from the investor’s perspective) as: against the unhedged return:

Spot Effect= Unhedged Investment Return-Investment Return in Local Currency Spot Recovery= (Hedged Return-Interest Rate Differential)-Unhedged Return

Tracking Error Spot Recovery Ratio Elimination Ratio FX Hedge Spot Effect Unhedged Hedged TE Efficiency Score Local Return Unhedged Return (USD against Hedged Return IRD (GBP against Relative Spot Spot Recovery Tracking Tracking Elimination (USD) (GBP) GBP) (GBP) USD) Spot Recovery Performance Ratio Error Error Ratio 10.00% 5.00% -5.00% 12.50% 0.50% 7.00% 2.00% 60.00% 10% 1.25% 87.50% 52.5% 10.00% 5.00% -5.00% 12.25% 0.50% 6.75% 1.75% 65.00% 10% 1.00% 90.00% 58.5% 10.00% 5.00% -5.00% 12.00% 0.50% 6.50% 1.50% 70.00% 10% 0.75% 92.50% 64.8% 10.00% 5.00% -5.00% 11.75% 0.50% 6.25% 1.25% 75.00% 10% 0.50% 95.00% 71.3% 10.00% 5.00% -5.00% 11.50% 0.50% 6.00% 1.00% 80.00% 10% 0.40% 96.00% 76.8% 10.00% 5.00% -5.00% 11.25% 0.50% 5.75% 0.75% 85.00% 10% 0.30% 97.00% 82.5% 10.00% 5.00% -5.00% 11.00% 0.50% 5.50% 0.50% 90.00% 10% 0.20% 98.00% 88.2% 10.00% 5.00% -5.00% 10.75% 0.50% 5.25% 0.25% 95.00% 10% 0.10% 99.00% 94.1% 10.00% 5.00% -5.00% 10.50% 0.50% 5.00% 0.00% 100.00% 10% 0.00% 100.00% 100.0% 10.00% 5.00% -5.00% 10.25% 0.50% 4.75% -0.25% 95.00% 10% 0.10% 99.00% 94.1% 10.00% 5.00% -5.00% 10.00% 0.50% 4.50% -0.50% 90.00% 10% 0.20% 98.00% 88.2% 10.00% 5.00% -5.00% 9.75% 0.50% 4.25% -0.75% 85.00% 10% 0.30% 97.00% 82.5% 10.00% 5.00% -5.00% 9.50% 0.50% 4.00% -1.00% 80.00% 10% 0.40% 96.00% 76.8% 10.00% 5.00% -5.00% 9.25% 0.50% 3.75% -1.25% 75.00% 10% 0.50% 95.00% 71.3% 10.00% 5.00% -5.00% 9.00% 0.50% 3.50% -1.50% 70.00% 10% 0.75% 92.50% 64.8% 10.00% 5.00% -5.00% 8.75% 0.50% 3.25% -1.75% 65.00% 10% 1.00% 90.00% 58.5% 10.00% 5.00% -5.00% 8.50% 0.50% 3.00% -2.00% 60.00% 10% 1.25% 87.50% 52.5%

2 If the hedged return was 10.25% and the IRD over the period Tracking Error Elimination Ratio was 0.50%, the adjusted hedged return is 9.75%. Comparing that to the unhedged return of 5.00%, implies the spot recovery Tracking error is defined as the volatility of the return delta was 4.75%. The hedging goal is to offset the -5.00% spot effect, between two return series. Calculated in the same manner as therefore we are left with -0.25% attributable to other implemen- typical standard deviation of any return series, it can provide a tation related factors (relative spot performance). measure of the consistency of the hedging program.

The Spot Recovery Ratio can be calculated as: To begin, calculate the tracking error of the unhedged returns relative to the local asset returns to determine the magnitude abs(Spot Recovery + Spot Effect) Spot Recovery Ratio = 1 – ( ) of the tracking error improvement provided through the hedging abs(Spot Effect) program. To do this, simply calculate the daily return differences of the unhedged relative to local asset return series. Once these To ensure equal penalty for both positive and negative relative returns are available, calculate the standard deviation of this spot performance of the hedge, we measure its absolute value series. (remember, the goal is not to enhance performance through active management, but to eliminate risk). In this scenario, the Next, perform the same calculation for the hedged returns rela- hedge captured all but 0.25% of the spot effect, representing tive to the local asset returns to determine the tracking error of a 95.00% recovery rate. The remaining spot FX exposure not the hedged returns. Assume the tracking error of the unhedged recovered may be the result of any number of implementation series is 10.00% while the tracking error of the realized hedged factors as mentioned above. series is 0.10%, the tracking error reduction ratio is simply cal- culated as:

Tracking Error Elimination Ratio = 1 – (Hedged TE/Unhedged TE)

In our example, the hedged performance eliminated 99.00% of the tracking error resulting from FX exposure.

FX HEDGE EFFICIENCY Score Tracking Error Spot Recovery Ratio Elimination Ratio FX Hedge Finally, to determine the FX Hedge Efficiency Score, simply Spot Effect Unhedged Hedged TE Efficiency Score multiply the ratios: Local Return Unhedged Return (USD against Hedged Return IRD (GBP against Relative Spot Spot Recovery Tracking Tracking Elimination (USD) (GBP) GBP) (GBP) USD) Spot Recovery Performance Ratio Error Error Ratio 10.00% 5.00% -5.00% 12.50% 0.50% 7.00% 2.00% 60.00% 10% 1.25% 87.50% 52.5% FX Hedge Efficiency Score = Spot Recovery Ratio × Tracking Error Elimination 10.00% 5.00% -5.00% 12.25% 0.50% 6.75% 1.75% 65.00% 10% 1.00% 90.00% 58.5% Ratio 10.00% 5.00% -5.00% 12.00% 0.50% 6.50% 1.50% 70.00% 10% 0.75% 92.50% 64.8% 10.00% 5.00% -5.00% 11.75% 0.50% 6.25% 1.25% 75.00% 10% 0.50% 95.00% 71.3% A perfect score would result from recovering 100% of the spot 10.00% 5.00% -5.00% 11.50% 0.50% 6.00% 1.00% 80.00% 10% 0.40% 96.00% 76.8% effect, while eliminating 100% of the tracking error. While a flaw- 10.00% 5.00% -5.00% 11.25% 0.50% 5.75% 0.75% 85.00% 10% 0.30% 97.00% 82.5% less score is not practically achievable, the FX Hedge Efficiency 10.00% 5.00% -5.00% 11.00% 0.50% 5.50% 0.50% 90.00% 10% 0.20% 98.00% 88.2% Score can form a basis for peer group comparison, provider per- 10.00% 5.00% -5.00% 10.75% 0.50% 5.25% 0.25% 95.00% 10% 0.10% 99.00% 94.1% formance evaluation and program calibration. 10.00% 5.00% -5.00% 10.50% 0.50% 5.00% 0.00% 100.00% 10% 0.00% 100.00% 100.0% 10.00% 5.00% -5.00% 10.25% 0.50% 4.75% -0.25% 95.00% 10% 0.10% 99.00% 94.1% Ultimately, managers owe it to their end investors to demon- 10.00% 5.00% -5.00% 10.00% 0.50% 4.50% -0.50% 90.00% 10% 0.20% 98.00% 88.2% strate the effectiveness of the products they offer. In a world of 10.00% 5.00% -5.00% 9.75% 0.50% 4.25% -0.75% 85.00% 10% 0.30% 97.00% 82.5% increased demand for transparency and an abundance of invest- 10.00% 5.00% -5.00% 9.50% 0.50% 4.00% -1.00% 80.00% 10% 0.40% 96.00% 76.8% ment choices, offering investors a simple way to evaluate your 10.00% 5.00% -5.00% 9.25% 0.50% 3.75% -1.25% 75.00% 10% 0.50% 95.00% 71.3% success can open the door to new business. Whether the FX 10.00% 5.00% -5.00% 9.00% 0.50% 3.50% -1.50% 70.00% 10% 0.75% 92.50% 64.8% Hedge Efficiency Score highlights how well a hedging program 10.00% 5.00% -5.00% 8.75% 0.50% 3.25% -1.75% 65.00% 10% 1.00% 90.00% 58.5% is run or sheds light on areas of improvement, managers only 10.00% 5.00% -5.00% 8.50% 0.50% 3.00% -2.00% 60.00% 10% 1.25% 87.50% 52.5% stand to gain from a better understanding of their performance.

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INVESTOR SERVICES Jay Moore is a Senior Vice President and the Global Head of Currency Administration at Brown Brothers Harriman.

Jay joined BBH in 2012 to lead the firm’s Product Development efforts for Foreign Exchange and has since transitioned to run the Currency Administration business. Prior to joining the firm, he was the head of the Currency Management and Portfolio Solutions Strategy teams for State Street Global Markets. He has 15 years of experience in the foreign exchange industry, including time within operations, trading, research, sales and product development. Jay Moore Senior Vice President Jay is a frequent speaker at industry conferences and his written work has been published in a number of [email protected] prominent financial journals and periodicals. 212.493.4903

Jay holds a Bachelor of Science degree in finance from the University of Connecticut. He has also been awarded the Chartered Financial Analyst (CFA) designation.

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