Cash Management - An Overview

Currency management focuses on seeking to obtain returns by managing the risk of changes to foreign exchange (FX) rates. Foreign exchange risk occurs when ever a fund manager is holding assets denominated in a currency other than the fund’s base currency. These asset’s returns can be viewed as being derived from two sources: firstly from changes to the prices of the asset in local currency terms and secondly, from change to the level of the currency. If manager are concerned about the immediate prospect for the currency, they may well hedge their foreign exchange exposure, while leaving the underlying asset holding in place.

The management of currency risk differs from other asset management activities in the following ways. Firstly currency exposure is derived from holding in other assets (equities, bonds, property cash etc). For currency management purpose, exposures from all of these asset classes are grouped together by currency as in the table opposite. The fund manager will compare this summarized position with the current house view on prospects for each currency and, in some instances, with a specific currency exposure bench mark. If he wishes to change his position, he will move the fund in to line with his desired currency position through purchasing or selling forward foreign exchange contracts. These are commitment to buy or sell a pair of currencies (e.g. ‘buy US dollar, sell sterling ‘) at a pre – agreed exchange rate at an agreed time in the future. The effect of these contracts is that, for the period of time that the contracts are in place, the fund manger will have increased his exposure to one currency and reduced his exposure to the other .


Currency management is often referred to a s on overlay management process, i.e. ‘overlaying‘underlying security positions with forward FX contracts to achieve a desired net currency exposure. A significant factor is the relative ease with which fund manager can change their currency positions. FX Markets are highly liquid, particularly for major currencies, making it very easy to make huge changes to exposures. There is an interesting trade – off when looking at fixed interest funds. If interest rates rise, in for example, Japan, The normal effect will be that bonds fall in value, but at the same time they yen will appreciate. Thus for a sterling – based funds the interesting metric is the net effect of these two influence on the value of the fund.


FX Rate are quoted as either ‘spot’ (generally setting in two days from the trade being struck ) or ‘forward’ ( generally setting any time up to one year from trade date). It is the current spot rate that is used to calculate the current value of holding denominated in currencies other than the fund base currency, whilst forwards rates are those for agreeing now to exchange an amount of one currency for another at a point in the future , essentially looking the fund in to the current market exchange rate . FX rates usually move in the same direction as the currency’s relevant domestic interest rate (i.e., US domestic interest rates for US dollars, Japanese rates for yen etc.. The close relationship between foreign exchange levels and relative interest rate (i.e., the difference between domestic interest rates pertaining to different currencies) is explained by the covered interest arbitrage theory. This theory also enables rates and interest rate differentials. Covered interest arbitrage is outlined in..


Appendix II

FX rates are generally quoted in terms of the US dollar which acts as the global financial world’s reference currency. ‘Cross rates’ are also quoted between most major currencies. e.g. Sterling/ yen , euro /yen etc/ The market is dominated by the major currencies , which are the US dollar, Yen and Euro .The main new development in recent year is the hugely ambitious euro project. An overview of the implication of this project is contained in.


Currency Analysis:

For the purpose of making allocations and controlling risk, currencies are generally grouped in to ‘blocs’, these being groups of currencies with high correlations of volatility of returns . An example hierarchy might be as in the diagram opposite. This hierarchy would be established by currency analysts, who would identify patterns of co- movements amongst currencies. The portfolio manager would seek to diversify his currency risk across these currency blocs as far as possible, for the same reasons that he will seek to diversify the holding underlying the currency risks that is to achieve superior risk adjusted returns.


Dealing and Administration

As mentioned above, currency management is carried out by means of forwards FX trades. These are generally carried out in pairs of currencies (e.g. buy sterling forwards, sell Japanese yen forwards) simultaneously bought and sold forwards to the same date for a pre – agreed amount. It is obviously important that these positions are maintained (if required) by the fund manager. Depending upon whether the funds manager has made a profits or loss on the FX trade, he may need to ‘top up’ the FX positions at this rollover point out of cash.

The forwards FX contract obliges the fund manager to deliver a pre set amount of the sold currency (US$ 32,500,000 in our earlier example) and to receive in exchange a pre – set of the bought currency (20, 000, 0000. in order to do this, the fund manager will need to ensure that he will be able to transfer the sold currency on the maturity date. he needs to generate two spot FX deals was struck in our example) in order to ensure that settlement can take place.

The Series of trades / actions will, therefore, be as follows:

Buy / Receive
Sell Deliver
Day 1 Six Month Forwards FX Trade 20,000,000 $ 32,500,000
Day 180 Spot Trade $ 32,500,000 19,877,676
Day 182 Cash Settlement 20,000,000 $ 32,500,000

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