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IFSWF Subcommittee #2
Case Study #2: Managing Currency Exposures of Financial and non-Financial Assets
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Preliminary case study objectives
To develop a unified, optimal currency hedging framework for Sovereign Wealth
Funds (SWFs) that accounts for both financial assets and non-financial assets (i.e.,
natural resource exposure).
To identify solutions that could be useful to the broadest possible set of SWFs,
while recognizing that each SWF has unique challenges, constraints, and objectives
and that as such, no single approach will be appropriate for all SWFs.
Note: this work is ongoing – all findings are preliminary.
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Outline
1. Introduction to Alberta’s Heritage Fund
2. Hedging the financial portfolio only
3. Oil, the U.S. dollar, and provincial revenues
4. Hedging the financial portfolio and oil royalties
5. Conclusions
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Introduction to Alberta Heritage Savings Trust Fund
Mission: Provide prudent stewardship of the savings form Alberta’s non-renewable
resources by providing the greatest financial returns on those savings for current
and future generations
The Alberta Heritage Fund is Alberta’s main long-term savings fund. The income
produced by the fund today forms part of general revenues which pay for
government programs essential to Albertans like health care and education. The
Heritage Fund and related endowments contribute about $1.25 billion toward
revenue.
A new asset mix was approved for the Heritage Fund in 2009 that calls for
increased investment in non-Canadian dollar denominated assets. This exposes
the fund to increased currency risk.
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Motivation: the exchange rate matters
If the Heritage Fund were a typical Canadian endowment fund, the currency
hedging question would be fairly straightforward: do we hedge the exposure back to
Canadian dollars and at what ratio?
However, the fund is an integrated part of the Province of Alberta’s balance sheet.
The largest item on the notional balance sheet is not the $15 billion Heritage Fund,
but rather the extensive in-the-ground reserves of bitumen, oil, and natural gas.
These reserves are in effect all U.S. dollar-denominated assets.
The 2011 budget reports that a one cent change in the CAD/USD exchange
rate results in a $154 million change in revenue. This is a larger impact on
provincial revenues than a $1 change in the price of oil.
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Hedging the financial portfolio only
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Currency exposures of the Heritage Fund
Portfolio Composition and Currency Exposure (%)
Assets Weight Canadian Bonds 20.0Real Estate 17.5Global Infrastructure 12.5Foreign Equities 42.0Canadian Equities 8.0
Currencies to HedgeExposure as % of
Total Portfolio EUR 9.3GBP 4.2JPY 4.4USD 20.7
Correlations
Portfolio EUR GBP JPY USD
Portfolio 1.00
EUR 0.20 1.00
GBP 0.05 0.64 1.00
JPY -0.21 0.53 0.45 1.00
USD -0.17 0.46 0.57 0.75 1.00
*We use the following proxies (same order as the table at left): DEX Universe Bond Index, IPD Large Institutional Property Index, S&P Global Infrastructure, MSCI All Country World Index, and S&P TSX Composite. We estimated correlations from monthly data over the period from December 2001 through September 2010. We also estimate standard deviations (not shown) which averaged 10% for currencies.
NOTE: This preliminary analysis is based on the policy portfolio and does not account for the fund’s actual offshore holdings (e.g., in Chile and Australia).
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Risk-minimizing hedge ratios: financial portfolio only
0 20 40 60 80 1008.0
8.5
9.0
9.5
10.0Portfolio Risk vs. Amount Hedged
0% Hedge Ratio100% Hedge RatioOptimal Uniform Hedge RatioOptimal Currency-Specific Policy
Amount Hedged (%)
Po
rtfo
lio R
isk
(%
)
Optimal Hedge Ratios (%) Optimal
0% 100%Currency-Specific
Hedge Ratio Hedge RatioHedging Policy
Hedgeable Exposure 39 39 39Total Hedge Positions 0 39 9 EUR 0 100 100GBP 0 100 0JPY 0 100 0USD 0 100 0
Expected Return 6.1 6.1 6.1Portfolio Risk 8.3 9.2 8.1
Preliminary conclusion: Currencies add diversification; hedging foreign currencies (with the exception of Euros) would actually have increased risk since 2001.
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Oil, the U.S. dollar, and provincial revenues
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The inverse relationship between oil and USD/CAD*
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Three-Year Rolling Correlation
*The dotted red line indicates the threshold for statistical significance.
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Why is the correlation negative?
*The dotted red lines indicates the threshold for statistical significance.
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GDP - Oil Price (in USD) Correlation
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Why is the correlation negative?D
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Canadian Oil and Gas Industry – Market Capitalization Weight
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Why is the correlation negative?
Over the past decade, oil has played an increasingly prominent role in the
Canadian economy.
The correlation between oil prices and the USD/CAD exchange rate (that is, the
price of one U.S. dollar expressed in Canadian dollars) has decreased from a -10%
to -20% range during the 1980s and 90s to approximately -60% today.
This strong negative correlation is intuitive; if Canada’s economic output and stock
market are positively correlated with oil, than we would also expect the Canadian
dollar (as observed from other countries) to exhibit a positive correlation with oil.
From a Canadian perspective, the relationship is inverted: when oil goes up, the
Canadian dollar also goes up and the U.S. dollar depreciates.
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Hedging the financial portfolio and oil royalties
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Defining outcomes for Alberta
“OKAY”
Oil prices up
USD down vs. CAD
“UNPLEASANT”
Oil prices down
USD down vs. CAD
“EXCELLENT”
Oil prices up
USD up vs. CAD
down up
“OKAY”
Oil prices down
USD up vs. CAD
do
wn
up
USD/CAD exchange rate
Oil
pri
ces
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Percentage of past 60 months in each quadrant
Okay Excellent Unpleasant0
10
20
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80
67
21
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Conclusion: Due to the negative correlation, “Okay” months occur far more frequently than “Excellent” or “Unpleasant” months. The USD is a natural hedge against oil prices for Alberta.
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A potential framework: Monte Carlo simulation
We identify two distinct regimes reflecting no correlations (Regime 1) and the recent
correlation structure (Regime 2).
Based on Regime 1 assumptions, we simulate 10,000 ten-year valuation paths for oil,
the exchange rate, and the portfolio.* We simulate another 10,000 for Regime 2.
We examine the impact of three hedging strategies across the 10,000 paths: (1) no
hedging, (2) hedging 50% of the USD exposure in the financial portfolio, and (3)
hedging 50% of the USD exposure in expected oil revenues.
Correlations
Portfolio Oil USD/CAD Portfolio Oil USD/CAD
Portfolio 1.00 1.00Oil 0.00 1.00 0.50 1.00USD/CAD 0.00 0.00 1.00 -0.50 -0.50 1.00
Regime 2Regime 1
*We also make assumptions regarding: (a) the standard deviations of the portfolio, oil, and the exchange rate, (b) expected returns for the portfolio, and (c) a spending rule for withdrawing cash from the financial portfolio. However, we hold each of these assumptions constant across the two regimes.
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Preliminary results: volatility of provincial revenues
Assuming no correlations Assuming recent correlations3.0
3.2
3.4
3.6
3.8
4.0
4.2
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4.6
4.8
No hedging
Hedge 50% of financial portfolio
Hedge 50% of last year's oil revenue
Preliminary conclusion: Due to the natural hedge, revenue volatility is lower assuming recent correlations than assuming no correlations. Also, hedging marginally reduces volatility assuming no correlations and actually increases volatility assuming recent correlations.
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Preliminary conclusions and next steps
If the negative correlation between the U.S. dollar and oil prices persists into the
future, then we can expect “OK” outcomes to occur with much greater frequency than
“excellent” or “very unpleasant” outcomes.
This correlation structure could represent a “natural hedge” for Alberta. If the current
environment prevails going forward, hedging U.S. dollar exposure could actually
increase the volatility of the cash flows Alberta derives from oil royalties and its
financial portfolio.
Alberta will continue to undertake research and analysis on these issues.