Policy: Investment foreign currency management

Purpose

This Investment Foreign Currency Management policy documents the University’s foreign currency management for the Long Term Investment Pool as part of the overall management of its investment assets. This policy is not related to the operational foreign currency management of the University.

Overview

The Foreign currency management policy details the key objectives of the foreign currency exposure within the University’s investments:

• foreign currency management is consistent with the long term investment objectives outlined in the Investment policy;
• investments in overseas asset classes are made to achieve industry and geographical diversification to enhance the overall return of the portfolio and to reduce risk;
• foreign currency is not a separate asset class; and
• currency markets are volatile and currency exposures impact the foreign currency-denominated investment returns. Foreign currency exposure is to be managed.

Scope

This policy applies to all funds held in the University’s investment portfolio.

Definitions

LTIP means the Long Term Investment Pool.

SAA means strategic asset allocation.

Policy statement

Background

1. The University is a long term investor and considers the following when determining its foreign currency exposure:

Risk reduction

• Depending on the relationship between the return of the currency and the return of the foreign asset in local currency terms, it may theoretically be beneficial to maintain foreign currency exposure on the grounds of reducing overall volatility.
• Inflation erodes purchasing power of a currency, thus demand for a currency typically falls when inflation is expected to be higher relative to another currency. Under Purchasing Power Parity (PPP) Theory, currency movements “correct” for relative inflation levels. Thus, foreign currency exposure acts as a hedge against relatively higher domestic inflation.
• The strength of reversion to PPP levels is typically weak and there is historical evidence of significant over and under-valuations relative to PPP levels persisting for many years. Purchasing Power Parity Theory tends to better explain movements in currencies over the very long term.

Hedged

2. Portfolios with the currency exposure completely hedged experience the following return outcomes:

• protection from movements in the value of the currency and;
• hedging the currency exposure allows the capture of the “hedge-pick up” or the interest rate differential between the monetary policies of the two countries.

Unhedged

3. Portfolios with the currency exposure completely unhedged experience the following return outcomes:

• there is no protection from movements in the value of the currency. The value of the underlying foreign asset decreases in Australian dollar terms should the AUD appreciate: and
• the value of the underlying foreign asset increases in Australian dollar terms should the AUD depreciate.

Approach to foreign currency management

4. The Council, through its Finance Committee, approaches currency management in the following manner:

• the foreign currency exposures are considered at the total portfolio level;
• a dynamic approach is applied to managing currency exposure; and
• foreign currency assets are left unhedged where the cost or complexity of hedging is prohibitive, or if there is strong expectations that those currencies will appreciate over the medium to long term (for structural reasons rather than dynamic valuation reasons).

Risk management

5. The Council, through its Finance Committee, has regard for the various risks associated with currency management. The key risks of currency management include:

• market risk is the risk of loss arising from movements in currency market movements;
• counterparty (credit) risk is the risk of loss due to the default by a counterparty to meet its obligations under a currency transaction; and
• reporting risk is the risk the University is not able to accurately ascertain the value of its foreign currency exposures in the LTIP.

Foreign currency exposure management

6. The table displayed below reflects the SAA foreign currency range for the LTIP.

Dynamic currency management framework

7. The Council, through its Finance Committee, and subsequently through the Investment Office, applies a dynamic approach to managing currency exposures with a view to achieving the objectives of currency management. These decisions are consistent with the University achieving its long term investment objectives.
8. The Finance Committee considers the following factors when determining changes in the levels of foreign currency exposures:

• economic conditions;
• valuations; and
• sentiment.

9. The table below reflects the suggested dynamic ranges for the foreign currency exposures for the LTIP.

10. The Investment Office achieves the desired foreign currency exposure through the following mechanisms, the:

• allocation to asset classes with foreign currency exposure and;
• level of currency hedging within asset classes with foreign currency exposure

Implementation

11. The Investment Office implements currency hedging within the ranges of the SAA (see paragraph 6). When desired, specialist investment managers with expertise in currency management are employed when active currency management in a hedging overlay structure is desired.
12. Implementation of currency management is completed in accordance with the use of derivatives as stipulated in the Investment policy and the Derivative Risk Management policy (Section 6).
13. Currency management are undertaken using the Australian dollar as the base currency.
14. Currency management activities are limited to the establishment of an adjustment of, long only positions of the Australian dollar. No net short positions of the Australian dollar are held.
15. Currency management activities have an absolute limit of 100% of the current market value as established by the custodian.
16. It is permissible to have different exposures in relation to individual currencies and the desired level of foreign currency exposure within the portfolio. For example, the desired level of foreign currency exposure for the LTIP could be 20%, however the exposure to the Japanese Yen on Japanese domiciled assets within the portfolio may be 100%.

Counterparties

17. Contracts are only established with counterparties with the highest credit rating of A1/P1 or better for short term payment ability. Approved counterparties and limits are established by the Director of the Investment Office with the initial approval of the Finance Committee and reviewed periodically.
18. The Director of the Investment Office notifies the Chief Financial Officer of any changes to either the approved Counterparty List and or the respective limits within five business days.

Benchmark

19. The performance of currency management is applied against the strategic benchmark of the LTIP on a monthly basis.

Reporting

20. The custodian calculates and reports the month-end LTIP’s foreign exchange exposure and hedge ratio calculations each month on the sixth business day.
21. Portfolio valuations and foreign currency exposures, including hedge ratios, are provided to the Finance Committee by the Investment Office at each Finance Committee meeting where Investments is on the agenda.
22. Foreign currency exposures are within tolerance limits previously approved by the Finance Committee at the time of reporting to the Finance Committee. Should the foreign currency exposure exceed the tolerance levels, the Investment Office is required to correct these levels to within tolerance within two business days.

Review of this policy

23. This policy is reviewed at least annually by the Finance Committee or more frequently if:

• meaningful change is made to the investment selection process; and
• relevant legislation or regulation requirements change.

24. When required, the Corporate Governance and Risk Office audits and reports to the Audit and Risk Management Committee and the Finance Committee on the appropriateness of, and compliance with, this procedure.

Roles and Responsibilities

25. The custodian calculates and reports the month-end LTIP’s foreign exchange exposure and hedge ratio calculations each month on the sixth business day.
26. The Investment Office performs an independent check on the custodian’s foreign exchange exposure and hedge ratio calculations within two business days of receiving the custodian report.
27. The Investment Office executes foreign currency hedges under delegation (Number 461), not exceeding 10% of the underlying currency exposure in any one day. Finance Committee approves currency hedges in excess of 10% of the underlying currency exposure.
28. The CFO can also execute foreign currency hedges under delegation (Number 461), not exceeding 10% of the underlying currency exposure in any one day and can set a variance of +/- 10% in the target hedge position established by Finance Committee.
29. The Finance Committee sets target hedge ratios and can approve execution of foreign currency hedges of the underlying currency exposure with no limit.