The Currency Conundrum: Case Study
IN PRINT ARCHIVE CIR Winter 2001
|The Currency Conundrum|
|Michael Keenan - Director of Policy and Research, Bimcor Inc.|
|Currencies are tricky. We analyze them in risk-return space to estimate efficient hedge ratios. But currency decisions are not like asset mix decisions, in which the risk and return trade-offs are reasonably predictable, at least in the long run.|
Equities deliver the highest returns, but be prepared to face some years of heart-stopping declines. The size of these declines can reliably be reduced by leavening the portfolio with other assets such as bonds or real estate, although this comes at the expense of some long-run return. The seasoned investor will look at her investment objectives, gauge her tolerance for taking losses and select an asset mix that tries to successfully balance the risk and return trade-off.
Currencies offer no such predictable trade-off. Theory suggests there might not be any returns. Purchasing power parity, for example, holds that the dynamics of international trade are such that real exchange rates should mean revert over the long term. Thus, currency gains and losses should wash out over time. If this theory isn't to your liking, then economics can also offer interest rate parity. Uncovered interest rate parity holds that forward exchange rates are unbiased predictors of future exchange rates, such that forward exchange rates should get it about "right" on average. Thus, there should be no long-term gain from hedging whichever direction the dollar may move in, because the hedger and the non-hedger are going to end up in the same place anyway.
But experience demonstrates that there can be sizable gains and losses from currencies and from currency hedging, at least in the short run. These gains and losses are often episodic and very difficult to forecast. For example, an investor in U.S. equities would have lost a significant amount by hedging the currency exposure in the late 1990s, in the face of tight Canada-U.S. interest rate spreads and a depreciating Canadian dollar.
The risk side of the equation can be just as murky. Currency hedging offers the potential for risk reduction in cases where currency returns are a substantial component of the total volatility of foreign asset returns, or where currency returns are positively correlated with the returns from other assets in the portfolio. But the interactions between currencies, interest rates, equity markets and other asset prices can be unstable, and total portfolio risk could increase from currency hedging as opposed to decreasing over any given period of time.
Moreover, all currencies are not created equal in terms of risk. Most important from a Canadian perspective is to recognize that the Canada-U.S. exchange rate is different animal than other major exchange rates. The Canada-U.S. exchange rate typically shows low annualized volatility in the range of 3 to 5 per cent, less than half of what is observed for other major currencies, and less than a third of what is observed for the Canadian dollar returns from foreign equity markets. An implication is that hedging the currency risk of a position in U.S. securities is less likely to reduce the overall risk of that position than with other currencies, because the exchange rate is likely to be a smaller component of the overall volatility.
So where does this leave investors in terms of developing a currency policy? Some comfort can be taken from the fact that currency effects seem to wash out substantially in the long run, even though economic theory doesn't always make the reasons clear. The combination of mean-reversion, relatively efficient forward markets and diversification across major currencies tends to make currency hedging a secondary determinant of overall long-run performance. For example, the investor losing money hedging the U.S. dollar in the late 1990s would have made money had she also been hedging European and Japanese exposures. Nonetheless, the potential for significant short- to medium-term surprises from currency trending suggests pension funds increasing their foreign asset allocations should be proactive and review the potential risks from currency exposures as well as update currency management policies. If performance relative to other pension funds is a consideration, it will be important to know what other funds are doing with foreign currency management. *