CURRENCY HEDGING IN EMERGING MARKET PORTFOLIOS: A CRITICAL CHALLENGE

Over the years, foreign investment has gained prominence around the world, and investors continue to invest significant portion of their assets in foreign equities. Investing in foreign equity may sound like an attractive opportunity to many, but at the same time, people tend to forget that while investing in foreign equity, they are also implicitly investing in foreign currency. Foreign currency has, through the years, played an essential role in trade and finance in emerging market economies (EME’s). Due to this fact, the investors are exposed to significant levels of foreign exchange (FX) risk in their portfolios. For example, a U.S. investor wanting to make a portfolio of large and mid-cap stocks in foreign equities will have approximately 50% of his portfolio impacted by foreign currency movement. Thus, the investor’s portfolio can be exposed to fluctuating exchange rates, which will have significant and unpredictable effects in return on foreign investments. The foreign currency also plays a dominant role in risks related to cash flow mismatches, changes in market sentiments, and currency crises. Therefore, the need for currency hedging in the FX derivative market in EME’s arises. Through this article, firms' exposure to the currency risks and hedging choices will be analysed. The article also answers the question of why firms in less liquid foreign exchange derivate markets, i.e., EME’s are exposed to systematic risk and have fewer options to hedge their currency risk. There is a growing need to sift through the jargon in order to focus more importantly on the need to hedge currency. Further, it is informative to connect and answer the above-stated question through the Chinese ‘Renminbi’ case study. Analysing this case study will help understand the importance of currency hedging in EME’s.

Understanding the Need

Hedging is defined as counter-balancing an investment and the risk associated with it through initiating a corresponding investment in another asset, and thereby trading off the risk so that the overall combination of risk is less. Firms generally do not want to expose themselves to market-wide risk considerations and therefore are willing to trade the risk arising from their daily businesses. Hence, the currency is hedged to protect these firms from unforeseen events that might impact the value of the currency. Hedging generally reduces the effect of foreign exchange fluctuation on businesses and/or investments. As stated above, investors who diversify their portfolios internationally are introducing a whole new asset class into their portfolios, i.e., currency, which can significantly impact overall portfolio risk and return. Many investors believe that currency comes implicitly packaged with the international equities they have invested in, and they also think that this implicit currency risk will play in their favour by offering meaningful returns to them. However, they fail to understand the very fact that foreign currency adds to the volatility of the international equities in their portfolio, thereby broadening their risk exposure. Even though the foreign currency is a prominent source of finance in EME’s, there is still a risk factor attached to it. Unexpected movement in security prices and currency exchange rates often leads to a currency crisis. Therefore, currency hedging is crucial as it acts as insurance, reduces firms' and investors' exposure to foreign exchange risks, and maintains the original equity exposure. Further, foreign firms that have subsidiaries in the emerging markets use currency hedging to avoid any loss due to fluctuation in the currency and to protect any disruptions in the cash flows and revenues of the company.

It is observed that the EME’s in the past were very volatile compared to the developed economies. However, over a period of time, the emerging markets and their currencies have become more stable, and there is low volatility due to which the firms have put in place long-term hedges. One of the glaring examples is the Chinese ‘Renminbi’, which was hedged by the corporates. Therefore, China grew with respect to exports and imports in the developed economies of Europe, America, and Asia. The critical consideration for hedging is due to the rate of interest prevailing in the EME’s in comparison to the developed economies. To be more precise, there is a wide gap in the interest rates of the Renminbi in contrast to the Euro and the Dollar. The interest rate drives a firm to hedge the currencies, which is efficient and cost-effective. Over a period of time, the Renminbi market become stable, and its growth trajectory became healthy and, therefore, hedging currencies in the present scenario proves to be beneficial for a firm rather than waiting for a fluctuation in the exchange rate of the currency, which may lead to volatility and thereby, exposing the firms and investors to more risk.

Brief Historical Comparison

It is pertinent to comprehend pre-existing literature and dwell on the nitty-gritty of foreign currency risks in both developed and EME’s to make a comprehensive argument. Although international portfolio diversification in developed economies improves portfolio performance, however, there is still a debate over whether hedging foreign currency risk yields the same result. Many economists and financial analysts have different opinions on the same. Some believe that hedging is like a free lunch that, to a large extent, reduces risk with little effect on the returns, and that portfolios formed by stock indices can be improved by hedging currency risk through forward markets. On the other hand, some are of the opinion that the cost of implementing currency hedging is so heavy that the benefits provided by the international asset (portfolio) diversification would be an overall better option. Lastly, it is also believed by some financial analysts that equity portfolios developed on stock indices of G5 countries benefit the developed market portfolio, and also currency hedging in forward markets further improves the performance of the portfolios. With all these ideas and attention to the developed countries, there is sparsely any literature on emerging markets. This could be because investing in EME’s is not yet mainstream. One should note that the global financial crisis of 2008-09 has raised the question of investing in the EME’s and revitalizing the importance of currency hedging in EME’s.

Analysing the Problem Statement

As we look at the need to hedge currency in the EME’s, it is also essential to understand and analyse why currency hedging in EME’s cannot be compared to that in developed economies. Currency hedging in EMEs is challenging and has very few options to hedge the risk. Three main issues to consider are:

i. Volatile political systems

This can also be framed as ‘expropriation risk’, i.e., The risk of the government seizing foreign-owned assets. Even though the risk of this happening has decreased by a lot ever since the 1980s, this risk now comes in a different form. As investments in the emerging economies have soared in the last decade, the risk of government altering laws or regulations in their own self-interests is still high.

ii. Issues with implementation

EME’s around the world experience challenges in both the availing currency hedging instruments and the exuberant expense associated with currency hedging. In EME’s, the trading volumes are minimal compared to their developed counterparts, and as a result, EME’s generally have lower levels of external investment and international trade. Lack of liquidity in emerging markets also reflects the government’s control over the capital. All these, in turn, result in the relatively high cost of currency hedging. In developed economies, with abundant liquidity and a liquid currency forward market, unwanted risks are absorbed and the cost of implementing a currency hedge is relatively low.

iii. Impact of currency on emerging market returns

The effect of hedging currency in emerging market portfolios is dependent mainly on the annual return of the emerging markets over that specific period of time. This shows that currency hedging in an emerging market severely hurts the investor as it is an upward moving market. Whereas, when a comparison is drawn with the developed economies, it is observed that the flat-to-downward moving market is beneficial for the investors. This implies that hedging currency in an emerging market economy essentially condenses the market exposure so as to reduce the returns to a portfolio significantly less than one beta.

Discussing these problems helps have a clear understanding of why the EME’s are still inferior compared to their developed counterparts. However, even though there are problems related to the implementation of currency hedging in the EME’s, there are still quite a few ways through which a better and more viable system can be formed. Firstly, keeping in mind that governments can have strong capital controls in the EME’s, the next best alternative is Cryptocurrencies. Cryptos, being a decentralised asset, also help the firms bypass the peculiarity of the government and its fiat currency. They help in counteracting the bureaucracy, opaque regulations, and volatile political systems. By doing this, the firms and consumers in the market are converting their currency volatility to a cryptocurrency. However, it is to be noted that the cryptos like Bitcoin are in no way perfect, and Bitcoin is much more volatile than many of the emerging market currencies. Therefore, Stablecoins should be considered as the best alternative to the fiat currency as they are decentralised assets and at the same time pegged to the fiat currencies- for example USDC or USDT.

Secondly, since the impact of currency exchange fluctuation can be very drastic on the EME’s, the best way to counter this problem is by giving more significance to multi-currency diversification. This helps control the exchange rate fluctuations, thereby improving the overall annual return of the EME’s over a specific period of time. Currency derivatives are the most sensible option to use in an EME as these are widely used to manage risks in developed economies. The main types of derivates used are currency forwards, futures and options. Though the cost of implementing them would be undoubtedly high for the EME’s, they will help design hedging strategies that would, in turn, reduce the risk produced from currency price movements.

Conclusion

To conclude, it is evident that there is a drastic difference between hedging in developed international portfolios and emerging-market portfolios. As discussed in the problem segment of the article, there are three key ways to understand the difference between emerging market portfolios and developed market portfolios. Firstly, it is expensive to hedge the currency in EME's, and/or the instruments are sparsely available compared to developed economies. Analysing the relationship between hedging currency and its returns in emerging markets showed that the benefits of hedging in the long term are relatively low compared to the short term. Lastly, the impact of political institutions on foreign exchange laws is also seen as a contributor to this problem. However, through implementing the solutions prescribed in this article, the low correlations of emerging markets with that of developed markets shift the portfolios frontiers in favour of the EME’s. The unconditional currency hedging realised by instruments like currency forwards and options improves the emerging market portfolios. Subsequently, the conditional hedging done by firms in EME’s helps decrease the risk of the portfolios. Thus, to sum it up, the decision of the investors and the firms to hedge currencies in an emerging market portfolio is essentially a “market call,” which is in favour of the emerging markets.

Cover Image: BNP Paribas

About the author: As a third-year law student, Aniruddh has acquired substantial research and practical skills in the various fields of law. He is a finance enthusiast and has completed an online specialisation course in DeFi and Blockchain Architecture, and has been working in various hackathons and research internships at the moment.