Currency Hedging in the Emerging Markets: All Pain, No Gain

Abstract

Investors in foreign equities are exposed to potential risks from both the movement of security prices and currency exchange rates. Over the past two years, the U.S. dollar has strengthened significantly against most developed and emerging-market currencies, resulting in material performance headwinds for U.S. dollar-based investors. This, in turn, has led to a growing interest in hedging the effects of currency movements on developed international equity holdings. As a consequence, many investors also wonder whether they should apply a similar program to their emerging- market assets. While this is a natural question, it ignores some of the major differences between implementing a hedging program for developed market currencies versus doing so for emerging-market currencies. We discuss these implementation issues and point out the historical relationship between stock price movements and currency returns in emerging markets. The authors find that for many emerging-market countries, these implementation issues make it operationally impossible to hedge many of these currency exposures; for those that are possible to hedge, the current market environment makes it very expensive Furthermore, if one looks at the theoretical impact from hedging currency in emerging markets, it appears to be a minor one over the long term and is equivalent to making episodic market calls in the short term.

TOPICS: Currency, emerging, interest-rate and currency swaps, performance measurement