20 September 2020
There are not too many topics in currency risk management that are as polarizing as the most basic question: whether one should hedge currency risk or not. Much less controversy exists about the need to hedge emerging market currencies. Many analysts and investors believe that hedging emerging market currencies is unnecessary. They offer various reasons: currency return is zero over the long term; currency trading costs are expensive; the cost of carry is too high; and collateralization of some currency positions encumbers cash or securities that could be used for other investment purposes.
This article examines the management of currency risk associated with an emerging market international equity portfolio from the perspective of an Australian dollar-based investor. Using the MSCI Emerging Markets Index to represent exposure to emerging market equities, we examine the effect currencies had on that portfolio during the period January 2001 to July 2020.
Currency markets are dynamic. That dynamism is reflected in changes in currency rates which, in general, change slowly. However, in periods of heightened volatility in other asset markets or when geopolitical events occur, the moves in currency can be abrupt and significant; these moves may take investors by surprise.
Some investors use a passive hedging strategy to manage this currency risk. Whether the investor decides to leave the portfolio unhedged (0% hedge ratio) or completely hedges the portfolio (100% hedge ratio) or chooses a hedge ratio in between, the chosen static hedge ratio is not likely to be the optimal strategy in all market conditions.