Using Currency to Hedge Risk in Emerging Markets

You can use currency to hedge against commodity price fluctuation, Trump's trade threats and even inflation

T. Rowe Price 14 July, 2017 | 9:55AM
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This article is part of the Morningstar's Guide to Emerging Market Investing. Here, as part of our Perspectives series, Andrew Keirle, portfolio manager of the T. Rowe Price Emerging Local Markets Bond Fund explains how currency can impact returns.

Actively managing currency positioning, rather than passively focusing on beta, is critical when investing in emerging markets local currency bonds.

While coupons have delivered most of emerging markets returns over the past decade, currency has been a major source of risk. Recent experience highlights the importance of considering these sources of risk and excess returns of a portfolio – and of isolating the individual drivers.

This can be achieved by employing a relative value currency strategy, which can help to reduce volatility and hedge against some of the larger risks, such as exposure to commodity prices.

In recent years, investors holding a passive long exposure to a basket of emerging markets currencies versus a large, undiversified short position in the US dollar would have lost out meaningfully, due to the stronger dollar. This illustrates the importance of actively managing currency. However, over time, the long-run strengthening trend of the US dollar could come to an end, removing this headwind for emerging market currencies.

For example, if a large proportion of holdings in a portfolio are driven by the same factor, such as the price of oil, the underlying risks of the portfolio may not be properly balanced. A way for investors to achieve a proper balance of risks would be to pair long positions in emerging market currencies against short positions in other developed or emerging market currencies, thus avoiding the need to take a directional view on the US dollar.

This is where relative value trades can help mitigate the currency risk. Instead of combining a long position in an EM currency, such as the Indian rupee, with a short position in the US dollar, the long rupee position could instead be paired with the British pound, Thai baht, or Australian dollar, among others.

Backing Russia’s Currency Paid Off

Avoiding excessive exposure to commodity prices, while capitalising on factors specific to a commodity-exporting country, is one area where we have used relative value currency positioning. For example, we expressed a favourable view on the Russian ruble by holding a long position in the ruble versus a short position in the Canadian dollar, both currencies being exposed to the price of oil. Similarly, a long position in the Brazilian real versus a short position in the Australian dollar allowed us to exploit the Brazilian currency, while hedging some of the risk of the price of iron ore – key export of both countries.

Beyond hedges on currencies exposed to commodity prices, there are other instances where relative value trades have allowed us to express views on particular emerging market currencies, while mitigating risk. After the US election last year, the Mexican peso depreciated steeply following comments President Trump had made about the future of US-Mexico relations. We believed the peso had become undervalued by as much as 20% as a result, and the market momentum around the trade was favourable.

However, we also wanted to hedge against the risk of a disruption to the NAFTA. This we achieved through establishing a long position in the peso versus a short position in the Canadian dollar, as both Mexico and Canada were exposed to this risk factor.

Another way to implement a relative value currency trade is by taking a short position in another emerging market currency. This typically involves putting on long positions in the currencies of countries with comparatively high yields, declining inflation and improving fundamental metrics – with short positions in the currencies of countries with lower yields, rising inflation and more challenging political situations.

Recent examples have included long positions in the Serbian dinar and Egyptian pound – both currencies of countries with slowing inflation – versus short positions in a basket of central and Eastern European currencies, where the inflation outlook appeared less attractive.

Similarly, relative value currency positioning can also be regional. This might entail taking two different emerging market currencies within the same region, to benefit from factors that are specific to a country, while reducing regional economic and geopolitical risks. For example, in Asia, holding an overweight position in the Indonesian rupiah versus a short position in the South Korean won.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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