Balancing Act
Getting the most from emerging market currencies

By Giulio Martini, chief investment officer, currency strategies, AllianceBernstein

Investment activity in the emerging markets has boomed in the past ten years—equity capitalization has tripled, fixed income volume has doubled, and private equity has increased. But the accompanying currency exposure has generally been viewed as a necessary evil, rather than as a potential source of enhanced returns. I believe this represents a missed opportunity.

Fundamentals in emerging economies have improved meaningfully over the past decade. Inflation has declined from an average of more than 20% in 1996 to just 4.1% last year and emerging countries have shifted from being net borrowers to net lenders. The resulting reduction in risk is reflected in the decline in the emerging market debt spread. Currency volatility has also fallen sharply.

The question is how best to use currency investing to exploit these improved fundamentals. The basic form of currency investing is to borrow—or go short—in a low interest rate currency to lend—or go long—in a high interest rate currency. You pay the interest rate on what you borrow and earn the interest rate on what you lend. Currency returns thus have two components: the interest rate differential, and the change in the exchange rate between the two currencies.

Long and short
We examined two basic passive currency investing strategies. A balanced-carry strategy simply goes long on currencies with positive relative interest rate differentials and short on currencies with negative ones, and the net investment exposure is always zero. A biased-carry strategy does the same thing, but net long or short positions are allowed. Both strategies have produced attractive results in the developed and emerging markets over the past decade. Looking at the longer history of developed market currencies, over the period from July 1979 (when the pound and yen were allowed to float freely) to December 2006, the balanced-carry strategy had a Sharpe ratio of 0.53 and the biased-carry strategy had a Sharpe ratio of 0.80. More importantly, on a rolling three-year basis the Sharpe ratios move up and down, but show no evidence of erosion over time. This suggests that the returns earned from currency investing are not a market anomaly, but that interest rate differentials embed a risk premium—much like the excess return that is earned by investors in equities or fixed-income instruments.

I would argue that high interest rate economies have high interest rates for reasons that relate to underlying fundamentals, as do low interest rate ones. The former are countries with inflation risk, cyclical economic risk, imbalances between domestic investment and savings that result in current account imbalances or fiscal deficits, or they may be countries that are viewed as being unreliable from the standpoint of monetary, fiscal, or regulatory policies. The market forces these countries to set short-term interest rates at levels that compensate for some of these risks and this is reflected in the positive returns embedded in exposures to positive carry.

In fact, you can see this by decomposing the returns earned in a simple long-only carry strategy between the U.S. dollar and the Thai baht, and between the U.S. and Canadian dollars. Both strategies earned positive returns. But source of the return differed: Thailand had had a positive interest rate differential, but the currency weakened against the dollar. The opposite is true with the Canadian dollar—the currency was fairly stable to strengthening, so the interest rate differential was flat to slightly negative. The Sharpe ratios for both strategies were almost identical.

With growing liquidity, the opportunities in emerging market currencies have increased substantially. The volume of the emerging world’s foreign exchange and derivatives market is more than US$56 billion, only a fraction of that of the developed world’s but still significant. Of course, transaction costs are higher for emerging currencies—an average of eight basis points versus three basis points for developed currencies—but the Sharpe ratios for the passive strategies, even after transaction costs, remained compelling. Overall, currency investing in emerging markets is a promising source of alpha.

To view Giulio Martini's presentation, click here.