Decomposition of Emerging Market Currency Risk: A Hedging Application

Abstract

As emerging market investments represent a growing proportion of global portfolios, the effective management of emerging market currency risk becomes more important. Many investors apply some form of currency hedging to manage the foreign exchange exposure inherent in international investments. This article addresses the question of what hedging policy is appropriate for emerging market currency exposure, contrasting the results when viewed from the perspective of different base currencies. A decomposition of risk and return demonstrates the significant role of the movements of the US dollar on the emerging market currency returns experienced by non-US investors. Intelligently hedging the US dollar component of emerging market currency risk would have provided non-US investors with a significant improvement in emerging market investment returns. In addition to asset allocation and stock selection, the cash flows generated by a well thought out currency hedging strategy can provide an additional way to outperform an emerging market equity index.

Keywords: Currency hedging, emerging markets currency, risk management, risk, exchange rates, FX