Six reasons why Fiduciary Management is much more than “LDI+DGF” – part 5 of 6

December 13, 2013 Categories: Investment Strategy

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Yesterday, in the fourth instalment of Six reasons why Fiduciary Management is much more than “LDI+DGF” we discussed the role of interest rate risk in the growth portfolio. In this blog I discuss the relationship between interest rates/inflation and currency risk:

5. FX risk as the point of intersection between growth and matching

For a pension scheme Asset and Liability investor FX (Foreign Currency) risk has a special role to play because of the way it interacts with domestic interest rates and inflation. An example of this can be seen from the 2008 devaluation of the pound. As a result of the devaluation of the pound there was an inflationary shock to the UK which directly impacted the real liabilities of pension schemes.

More immediately there is the relationship between real rate differentials in different markets and the currency exchange rates in those markets. The graph below shows the history of the 5 year real rate differential between the UK and the US and the exchange rate between sterling and the dollar:

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Source: Barclays Capital

The high correlation between FX rates and real interest rate differentials is a key factor to be considered when designing a pension schemes FX/liability hedging policy. Pension schemes which set there FX hedging policy based only on a single asset class or on the growth portfolio alone will have had too much hedging of FX risk to the UK’s major trading partners, the US and Eurozone.

Coming soon:

6. Impact of interest rates versus equity correlation

Stay posted…and for those in a hurry, click here

 

Gwion Moore – Director, Client Strategy & Research, EMEA

 

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