Financial analysts » Currency

EMERGING MARKETS AND CURRENCY HEDGING

admin — Mon, 06 Jul 2009 08:37:42 +0000

It has been noted that emerging markets have different market properties to those of the developed markets. Here, it is important to sell these out and then in turn relate them to the considerations of passive and active currency risk management. First off, let us look at the major differences that appear present in emerging markets:
Liquidity risk — Emerging market currencies are less liquid than their developed counterparts. For instance, every day some USD300 billion goes through EUR–USD. This compares with around USD10 billion daily in the South African rand. Needless to say, this lower liquidity affects pricing and price action.
Convertibility risk — Even less than liquidity risk, convertibility risk is not a consideration for developed currency markets as all major currencies are freely floating and fully convertible. A number of emerging market currencies however are still not convertible on the capital account, and indeed a few are still not fully convertible on the current account.
Exchange controls — In line with this, several emerging market currencies still have varying degrees of exchange rate controls, which also distort exchange rate pricing and economic activity. Exchange controls create “black market” activity and paradoxically can lead to capital flight.
Emerging markets have structurally high levels of inflation — Stronger growth levels and economic inefficiencies are important reasons behind structurally high levels of inflation relative to developed markets. This in turn means that policy interest rates are in most cases substantially higher in emerging markets than in developed markets, resulting in high forward premiums.
Capital inflows however can depress market interest rates — The size of global capital flows relative to the size of local capital markets in most emerging markets can mean that the latter are swamped by a relatively small portfolio shift in assets either into the market or out of it. As a result, interest rate volatility is a lot higher.
Forward rate bias is lower in emerging markets — While forward exchange rates are poor predictors of future spot exchange rates in the developed markets, this is less so in many emerging markets. The exhaustive 2000 study by Bansal and Dahlquist tested the presence of forward rate bias and found emerging market currencies show significantly less correlation between current interest rate differentials and subsequent spot returns than those in the developed markets. That said, emerging market currencies tend to appreciate on a real basis and then collapse to adjust for the trade balance deterioration caused by that real exchange rate appreciation.
Implied emerging market volatility below developed market volatility is a buy signal —
Historically, lower levels of implied volatility in emerging market currencies than the corresponding developed market currencies has proven a good buy signal for the former. Intuitively, emerging market volatility should be higher, though there are periods when the sheer weight of capital inflows forces it artificially lower. Note that emerging market implied volatility is skewed in that it tends to fall only when the emerging market currency is strengthening, but always rises when the currency weakens.
Implied emerging market volatility is a very poor predictor of future exchange rates —
Looking at previous emerging market crises, the options market has usually got it “wrong” in the sense that such crises have never been priced in ahead of time by the options market. Thus, we can say that the options market is a poor predictor of future exchange rate levels in the emerging markets, though measured against historic volatility levels it may well be a much better indicator of relative value.
What we find in the emerging markets is that shifts in global capital flows have major domestic interest rate implications. For instance, high inflation and therefore interest rate differentials should, according to classical economic theory, suggest a depreciation of the local currency in proportion to that interest rate differential or forward premium. However, this may not occur due to heavy capital inflows, which swamp the domestic market’s ability to cope with these without economic distortion. As a result of this, the currency may experience significant nominal and real appreciation, in seeming violation of the international Fisher effect and covered interest rate parity. Real currency appreciation however leads to a real economic shock, and more specifically real trade and current account balance deterioration. Eventually, this has to be reversed and not too surprisingly through real currency depreciation. The longer and more powerful the real appreciation, the potentially more violent the subsequent depreciation. Emerging market currencies trade in these types of cycles, in line with the “speculative cycle” that we looked at earlier in the blog. As a result, we can tell from this that the forward rate bias is extreme for emerging market currencies on both sides of the forward. In line with this, some caution is needed in using the differential forward strategy in the emerging markets. Emerging market interest rate differentials would mean theoretically that an investor never hedged emerging market currency risk using the differential forward strategy, yet this is clearly not the appropriate strategy in some cases.
For similar reasons, the carry trade has provided significant alpha for active currency managers, both in the basic and in the optimized version. However, the distortion to interest and exchange rates that capital inflows provide in emerging markets means that a significantly higher degree of both care and discretion is needed in picking higher carry currencies to either invest in or hedge depending upon the reading of the risk appetite indicator.

Adding “Alpha”

admin — Fri, 03 Jul 2009 08:34:47 +0000

The motive of risk reduction is primarily defensive, in that it seeks to defend or maintain the portfolio’s return within a given tolerance of overall risk. That for adding “alpha” on the other hand is quite different, in so much as “alpha” refers to the excess return generated by an active currency manager relative to a passive hedging programme.
Economic theory suggests that the long-term return of a currency is zero, so how can an active currency manager add value or “alpha”? There appear to be two aspects to this question. Firstly, currency markets are dominated by short-term movement. Thus, while their long-term return may be zero, their short-term returns (and losses!) may be significant. Secondly, it should be remembered that the same theory that suggested there were fundamental equilibrium levels for currencies also suggests that their long-term returns are zero. While not rejecting such a theory outright, it should surely be treated with some care, put in this context.
Indeed, there is a fine — and increasing — body of academic work that suggests that contrary to theory, managing currency risk can indeed add “alpha”. Among these, I will draw out several notable examples. Firstly, while formulating his “Universal Hedging Policy” in 1989, Fisher Black suggested that currency was, contrary to theory, not a zero sum game and investors could indeed increase their returns by holding currency inventories. Needless to say, this contradicted the widely held view that currencies could not provide added value because currency markets were perfectly efficient. A relatively short time after that, Mark Kritzman put forward the view that active currency managers could take advantage of the apparent serial correlation in currency returns. Subsequent research by Taylor (1990) and Silber (1994) targeted market trends as being behind persistent positive returns from currency managers.
Two further research reports that should be mentioned are those by Strange (1998, updated 2001) and The Frank Russell Company (2000). In the first case, the survey by Brian Strange, as published in Pensions and Investment (15/6/98), entitled “Do Currency Managers Add Value?” stated that of the 152 individual currency overlay programmes managed by 11 firms, these produced an average of 1.9% per year over a 10-year review period from 1988 to 1998, while simultaneously reducing the risk of the portfolio. In other words, not only did currency managers consistently add value, but their action of seeking to manage currency risk also helped lower the overall risk profile of the portfolio, thus boosting the Sharpe ratio from both sides! The second example is that of the Frank Russell study of May 2000 entitled “Capturing Alpha through Active Currency Overlay”, which analysed the historical performance of currency overlay mandates and confirmed the view that managing currency risk does indeed add value or “alpha”.
As noted above, a host of empirical studies have proven conclusively that active currency management can indeed boost the portfolio’s return, both on an absolute basis and in this context relative to not hedging, in contrast to classical exchange rate theory. In line with this, a number of studies have been published suggesting clear market inefficiencies, which might therefore be taken advantage of by active currency managers. For instance, the 1993 study by Kritzman, suggesting that the discount/premium of the currency forward contract “systematically and significantly overestimated the subsequent change in the spot rate”. Kritzman also introduced the concept of so-called “bilateral asymmetry”, referring to a bias by risk-averse investors for the perceived predictable returns of the interest rate differential as opposed to the unpredictable returns of the currency. Work by Choie (1993) supported these findings. Overall, a body of informed opinion has developed, supportive of the view that active currency management can add value.
After finally admitting that currency markets may offer profit potential, whether over the short or long term, academic theorists have suggested that such profit opportunities may exist in currency markets because there are some currency market participants that are not solely or even mainly motivated by profit. Classical theory suggests rational currency market participants are solely profit-seeking and moreover offset each other, with the result that any outstanding profit opportunities are instantly arbitraged away. Thus, from this, they seek to explain the existence of sustained profit opportunities within currency markets by suggesting that non-profit-seeking currency market participants such as central banks, tourists and national or corporate Treasuries effectively distort pricing. To me, such a view appears more reflective of the guesswork of someone who does not actually know the answer but is afraid to own up. Currency markets generate profits because it is the theory that they should not that is wrong rather than the currency market itself.
Active currency management can add value because there is value to be had in currency markets, plain and simple. Within this, an active currency manager will clearly favour the most flexibility possible to add that value, both in terms of the currency benchmark that they have to operate under and the currencies and financial instruments with which they are allowed to trade. For the active currency manager, the foreign currency return is not just a matter of currency translation of the underlying asset, but also of the excess return or alpha that the currency manager is able to add. The alpha an active currency manager generates is usually measured against an unhedged position. However, probably a truer idea of the alpha the active currency manager generates would come from comparing their returns to those of a passive currency management strategy of maintaining the benchmark hedge ratio. Historically, the typical mandate has allowed managers to vary the hedge ratio between 0 and 100% regardless of the benchmark.