Managing EM Currency Risk: The Options

This is an executive summary of our white paper on EM Currency Risk Management. Please contact us for a copy.

Emerging market (EM) currency exposure is generally expected to deliver positive returns on account of faster productivity gains and higher real interest rates relative to developed markets. However, EM currencies are more volatile than their developed market counterparts and are also sensitive to many of the same macroeconomic factors driving local equity and bond markets. This can add further pressure to portfolio performance during challenging market environments. Some investors therefore prefer to manage their EM currency risk.

The most apparent option is to remove all or part of the currency risk via passive hedging, which can considerably reduce both portfolio volatility and drawdowns. However, due to the existence of a positive expected return in emerging market currencies, these benefits must be carefully considered against a high cost of hedging. Passive hedging can also incur large cash flows, which may be disruptive if cash availability is limited, e.g. if the underlying assets are illiquid.

For investors principally concerned with drawdown protection, systematic active hedging can manage downside risk in an exposure that otherwise has positive long-term return prospects. Such a strategy tends to be rules-based and in contrast to passive hedging, hedges are only applied when currency returns are expected to be negative. As a result, the portfolio is not hedged all the time, allowing the investor exposure to EM currency as a potential source of return i.e. to partake in EM currency appreciation and higher local yields. This type of hedging strategy could incorporate multiple inputs (e.g. recent price action, currency valuations and purchasing power, and cost of hedging) to vary hedge ratios.

Other investors may value the ability to express a discretionary view or manoeuvre hedge ratios pre-emptively based on factors that systematic or static frameworks are less responsive to, such as political risks or other prevailing market conditions. In this case, discretionary active hedging may be more appropriate. Under the same banner, it is also possible to manage currency risk based on the evolving economic risk of individual investment projects, taking into account the denomination of asset/revenue and liability/cost streams. Additionally, environmental, social, and governance objectives can be integrated into EM currency risk management.

Another alternative to the above methods is EM diversification. This approach embraces the long-term return potential of EM currency exposure and is most appropriate for investors who recognize the rewarded risks embedded in EM currency, but prefer a more diverse and efficient currency allocation than that imposed by underlying equity investments. By recalibrating towards a more targeted set of exposures, based for example on carry, value and growth opportunities, EM diversification optimizes, rather than hedges out, EM currency risk.

The management of EM currency risk typically, but not always, involves transacting in currency derivatives. Local market conditions can vary widely within emerging markets, and in judging the feasibility and desirability of managing EM currencies, investors should consider the following factors: trading costs which can vary widely across currencies and market conditions; choice of instruments where, for example, offshore derivatives may be required; and official exchange rate policy such as exchange rate pegs which will affect the strategic decision to hedge.

In practice, managing EM currency risk embraces the full spectrum of methodologies outlined above. In the table below we summarize some key investor objectives along with our assessment of the effectiveness of each method. Ultimately, the most appropriate implementation will depend on the objectives and constraints of each individual investor.

Spectrum of EM currency management options

(Relative effectiveness scores: 1 =effective; 5 = ineffective)

Risk warnings

Issued in the UK by Record Currency Management Limited. All opinions expressed are based on Record’s views as of 25 February 2019 and may have changed since then. The views expressed do not represent financial or legal advice. Record accepts no liability should future events not match these views and strongly recommends you seek your own advice to take account of your specific circumstances. This material is provided for informational purposes only and is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities, Record Currency Management Ltd products or investment services. Any reference to Record products or service is purely incidental and acts as a reference point only for the purposes of this note. The views about the methodology, investment strategy and its benefits are those held by Record Currency Management Limited.

All beliefs based on statistical observation must be viewed in the context that past performance is no guide to the future. Changes in rates of exchange between currencies will cause the value of investments to decrease or increase. Before making a decision to invest, you should satisfy yourself that the product is suitable for you by your own assessment or by seeking professional advice. Your individual facts and circumstances have not been taken into consideration in the production of this document.

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