CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

29.6 FOREIGN CURRENCY EXPOSURE

One benefit of using futures to take market positions is that they come with a built-in currency hedge. This is because futures contracts have no net liquidating value. As a result, a position in Euro Stoxx futures makes or loses money only when the index rises or falls. A change in the dollar price of the euro would, by itself, produce neither a gain nor a loss, because the investor has no cash position in euros.

In contrast, the U.S. dollar return to a fully funded, currency-unhedged investment in Euro Stoxx would be, to a first approximation, the sum of the return on Euro Stoxx, as viewed by a euro-based investor, and the dollar return on the euro. Conventional money managers are well aware of the problems raised by currency risk because currency volatility is potentially very large. During periods of increased uncertainty in global markets, the currency volatility may contribute as much to the risk of a fully funded position as the volatility of the underlying asset, Euro Stoxx in this example.

For CTAs, the only foreign currency risk associated with using futures to trade comes from the value of cash or collateral balances that are the result of either posting margin collateral or accumulating gains or losses in currencies in which the contracts are denominated. Because these balances tend to be small relative to the notional values of the positions taken, foreign currency risk is, for all practical purposes, separate from the risks associated ...