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Currency Overlay in Reserve Management
In Figure 1 we show the performance of the strategies from 1979, covering almost the entire history
of flexible exchange rates since Bretton Woods (returns prior to August 2010 have been back-tested).
Each of the three strategies maximizes exposure to its factor by buying currencies with higher interest
rates against currencies with lower rates (carry), buying currencies that have strengthened most
against currencies that have weakened most (momentum) or buying currencies that are cheapest
relative to OECD Purchasing Power Parity
2
against currencies that are the most expensive (value).
Trend, carry and value are often referred to as “risk premia,” because they capture the premia
associated with the risks of holding currencies with high yield (associated with inflation pressures
and external deficits), strong momentum (risk of position saturation and reversal) and cheap value
(currencies that have weakened because they are unattractive).
Even simple and relatively passive currency strategies such as those shown in Figure 1 can offer
consistent returns with low correlation to traditional assets. For example, the correlation of monthly
returns between the three-strategy portfolio and MSCI World equity index has been just 7% (Jan-79 —
Jun-15, n=438, Bloomberg ticker MXWO Index). The same correlation with the Citi World Government
Bond Index has been -13% (Feb-85 — Jun-15, n=365, Bloomberg ticker SBWGL Index).
Figure 1: Cumulative Excess Return of CitiFX G10 Beta Strategies for 7% Annual Risk Target, % USD*
-20%
0%
20%
40%
60%
80%
100%
120%
140%
160%
180%
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15
Carry
Value
Momentum
Average of three strategies
Strategies
live
Strategies
back
-
tested
Carry Value Momentum Average
Annual return
4.4% 2.8% 2.9% 3.4%
Annual risk
7.5% 8.0% 7.1% 4.5%
Information ratio 0.59 0.35
0.41
0.74
Max drawdown -22.9% -35.1% -23.3% -10.3%
Source: Citi; Jan-79 — Jun-15 *Please see disclaimer regarding Hypothetical Results
So why should currency overlay be relevant for reserve managers? First, it offers an opportunity
to diversify reserves without having to shift underlying assets into markets where the bond market
liquidity may not be able to absorb significant new inflows. Second, we note that bid yield of the Citi
World Government Bond Index currently oscillates around historic lows of 1.1%. Many AAA countries
offer even less. This is well below the targets of most inflation-targeting central banks, suggesting
that reserve managers with high-grade government bond investments may see the real value of their
reserves fall over the medium term. Additional return sources are therefore increasingly important in
trying to maintain and grow reserve assets.
In order to demonstrate the value that currency overlay can add to reserve management we first
construct a benchmark portfolio. We do this by obtaining historical weights from the IMF’s Currency
Composition of Official Foreign Exchange Reserves (COFER) database and then apply them to Citi’s
local currency Government Bond Indices for the United States, United Kingdom, Euro area, Japan,
Switzerland, Canada, Australia, Norway and Sweden (the latter two are assigned to the COFER ‘other
currencies’ weight). The resulting portfolio, which is shown in Figure 2, represents performance of
a hypothetical reserve manager who measures itself in a basket of currencies corresponding to
COFER weights.
For Institutional Investors Only — Not for Onward Distribution
2
Purchasing Power Parity provides the level of the exchange rate that equates the cost of goods and services in two economies.
For more information, please see http://www.oecd.org/std/prices-ppp/