1. 1 IFSWF Subcommittee #2 Case Study #2: Managing Currency Exposures of Financial and non-Financial Assets

2. 2 Preliminary case study objectives  To develop a unified, optimal currency hedging framework for Sovereign Wealth Funds (SWFs) that accounts for both financial assets and non-financial assets (i.e., natural resource exposure).  To identify solutions that could be useful to the broadest possible set of SWFs, while recognizing that each SWF has unique challenges, constraints, and objectives and that as such, no single approach will be appropriate for all SWFs.  Note: this work is ongoing – all findings are preliminary.

3. 3 Outline 1.Introduction to Alberta’s Heritage Fund 2.Hedging the financial portfolio only 3.Oil, the U.S. dollar, and provincial revenues 4.Hedging the financial portfolio and oil royalties 5.Conclusions

4. 4 Introduction to Alberta Heritage Savings Trust Fund  Mission: Provide prudent stewardship of the savings form Alberta’s non-renewable resources by providing the greatest financial returns on those savings for current and future generations  The Alberta Heritage Fund is Alberta’s main long-term savings fund. The income produced by the fund today forms part of general revenues which pay for government programs essential to Albertans like health care and education. The Heritage Fund and related endowments contribute about $1.25 billion toward revenue.  A new asset mix was approved for the Heritage Fund in 2009 that calls for increased investment in non-Canadian dollar denominated assets. This exposes the fund to increased currency risk.

5. 5 Motivation: the exchange rate matters  If the Heritage Fund were a typical Canadian endowment fund, the currency hedging question would be fairly straightforward: do we hedge the exposure back to Canadian dollars and at what ratio?  However, the fund is an integrated part of the Province of Alberta’s balance sheet. The largest item on the notional balance sheet is not the $15 billion Heritage Fund, but rather the extensive in-the-ground reserves of bitumen, oil, and natural gas. These reserves are in effect all U.S. dollar-denominated assets.  The 2011 budget reports that a one cent change in the CAD/USD exchange rate results in a $154 million change in revenue. This is a larger impact on provincial revenues than a $1 change in the price of oil.

6. 6 Hedging the financial portfolio only

7. 7 Currency exposures of the Heritage Fund Portfolio Composition and Currency Exposure (%) AssetsWeight Canadian Bonds20.0 Real Estate17.5 Global Infrastructure12.5 Foreign Equities42.0 Canadian Equities8.0 Currencies to Hedge Exposure as % of Total Portfolio EUR9.3 GBP4.2 JPY4.4 USD20.7 Correlations PortfolioEURGBPJPYUSD Portfolio1.00 EUR0.201.00 GBP0.050.641.00 JPY-0.210.530.451.00 USD-0.170.460.570.751.00 *We use the following proxies (same order as the table at left): DEX Universe Bond Index, IPD Large Institutional Property Index, S&P Global Infrastructure, MSCI All Country World Index, and S&P TSX Composite. We estimated correlations from monthly data over the period from December 2001 through September 2010. We also estimate standard deviations (not shown) which averaged 10% for currencies. NOTE: This preliminary analysis is based on the policy portfolio and does not account for the fund’s actual offshore holdings (e.g., in Chile and Australia).

8. 8 Risk-minimizing hedge ratios: financial portfolio only Optimal Hedge Ratios (%) Optimal 0%100% Currency- Specific Hedge Ratio Hedging Policy Hedgeable Exposure39 Total Hedge Positions0399 EUR0100 GBP01000 JPY01000 USD01000 Expected Return6.1 Portfolio Risk8.39.28.1 Preliminary conclusion: Currencies add diversification; hedging foreign currencies (with the exception of Euros) would actually have increased risk since 2001.

9. 9 Oil, the U.S. dollar, and provincial revenues

10. 10 The inverse relationship between oil and USD/CAD* *The dotted red line indicates the threshold for statistical significance.

11. 11 Why is the correlation negative? *The dotted red lines indicates the threshold for statistical significance.

12. 12 Why is the correlation negative?

13. 13 Why is the correlation negative?  Over the past decade, oil has played an increasingly prominent role in the Canadian economy.  The correlation between oil prices and the USD/CAD exchange rate (that is, the price of one U.S. dollar expressed in Canadian dollars) has decreased from a -10% to -20% range during the 1980s and 90s to approximately -60% today.  This strong negative correlation is intuitive; if Canada’s economic output and stock market are positively correlated with oil, than we would also expect the Canadian dollar (as observed from other countries) to exhibit a positive correlation with oil. From a Canadian perspective, the relationship is inverted: when oil goes up, the Canadian dollar also goes up and the U.S. dollar depreciates.

14. 14 Hedging the financial portfolio and oil royalties

15. 15 Defining outcomes for Alberta “OKAY” Oil prices up USD down vs. CAD “UNPLEASANT” Oil prices down USD down vs. CAD “EXCELLENT” Oil prices up USD up vs. CAD downup “OKAY” Oil prices down USD up vs. CAD down up USD/CAD exchange rate Oil prices

16. 16 Percentage of past 60 months in each quadrant Conclusion: Due to the negative correlation, “Okay” months occur far more frequently than “Excellent” or “Unpleasant” months. The USD is a natural hedge against oil prices for Alberta.

17. 17 A potential framework: Monte Carlo simulation  We identify two distinct regimes reflecting no correlations (Regime 1) and the recent correlation structure (Regime 2).  Based on Regime 1 assumptions, we simulate 10,000 ten-year valuation paths for oil, the exchange rate, and the portfolio.* We simulate another 10,000 for Regime 2.  We examine the impact of three hedging strategies across the 10,000 paths: (1) no hedging, (2) hedging 50% of the USD exposure in the financial portfolio, and (3) hedging 50% of the USD exposure in expected oil revenues. *We also make assumptions regarding: (a) the standard deviations of the portfolio, oil, and the exchange rate, (b) expected returns for the portfolio, and (c) a spending rule for withdrawing cash from the financial portfolio. However, we hold each of these assumptions constant across the two regimes.

18. 18 Preliminary results: volatility of provincial revenues Preliminary conclusion: Due to the natural hedge, revenue volatility is lower assuming recent correlations than assuming no correlations. Also, hedging marginally reduces volatility assuming no correlations and actually increases volatility assuming recent correlations.

19. 19 Preliminary conclusions and next steps  If the negative correlation between the U.S. dollar and oil prices persists into the future, then we can expect “OK” outcomes to occur with much greater frequency than “excellent” or “very unpleasant” outcomes.  This correlation structure could represent a “natural hedge” for Alberta. If the current environment prevails going forward, hedging U.S. dollar exposure could actually increase the volatility of the cash flows Alberta derives from oil royalties and its financial portfolio.  Alberta will continue to undertake research and analysis on these issues.