Global Currency Hedging

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1 Global Currency Hedging John Y. Campbell Harvard University Arrowstreet Capital, L.P. May 16, 2010

2 Global Currency Hedging Joint work with Karine Serfaty-de Medeiros of OC&C Strategy Consultants and Luis Viceira of Harvard Business School Published in Journal of Finance, February

3 Global Currency Hedging Investment in foreign equity requires an implicit currency position that can be hedged in any desired proportion using forward contracts. What is the optimal hedging policy for an international investor? How can currencies be used to manage portfolio risks? Think of currencies as assets that can be added to a global equity (or bond) portfolio. Assume zero expected excess currency returns to calculate risk management (RM) demand for currencies. The optimal weights are determined by the betas of currency returns with the equity (or bond) returns. These weights imply an optimal currency hedging policy 2

4 Classifying Currencies The bottom line: A classification of currencies Reserve currencies (e.g. US dollar, the euro and Swiss franc) strengthen when world equity markets go down. Commodity-dependent currencies (e.g. Australian dollar, Canadian dollar) strengthen when world equity markets go up. Neutral currencies (e.g. Japanese yen, British pound) are close to uncorrelated with equity markets. 3

5 Our Findings Optimal RM currency demands Equity investors should hold reserve currencies Currencies are largely uncorrelated with bonds, so bond market investors should hold their base currency Currency risk and return Reserve currencies have had lower average interest rates and average returns But the return differences are modest Risk management and the carry trade Movements in interest differentials predict currency returns and hence speculative currency demands: the carry trade They predict risks and RM currency demands in, if anything, the same direction: the super carry trade 4

6 Our Data IMF s IFS database: Exchange rates Nominal interest rates, mostly three-month rates Long-term bond yields. MSCI database: Stock returns. We report results for seven countries (or regions): Euroland : Germany, France, Italy, and the Netherlands i.e. 78% to 92% of the market value of the 1999 euro countries Australia, Canada, Japan, Switzerland, UK and US. Monthly data, 1975:7 2005:12. 5

7 Single-Country Stock Portfolios 6

8 7

9 Equal-Weighted Global Stock Portfolio 7 countries: 14% invested in each country stock market. The investor can use the full array of currencies to manage risk. What currency exposure minimizes the volatility of this portfolio? In this case, when hedging using the full range of available currencies, the vector of optimal currency positions is independent of the base country. 8

10 9

11 Have Things Changed Over Time? In the 1990 s the euro started to move more strongly against world equity markets, making it a reserve currency. The Swiss franc moves with the euro, so it also became a reserve currency. The negative comovement of the dollar with world equity markets appears to have weakened. But what about the global financial crisis? Hold that thought. 10

12 11

13 12

14 Equal-Weighted Global Bond Portfolio 13

15 5 14

16 Currency Returns in Equilibrium Currencies systematically differ in their comovements with global stock markets. In equilibrium investors must be willing to hold all currencies (Black, 1990). Are currencies priced so that normal currencies offer higher average returns than reserve currencies? If so, governments with reserve currencies benefit from lower funding costs: the exorbitant privilege 15

17 Currency Returns in Equilibrium Reserve currencies do tend to have lower average interest rates than other currencies, with the exception of the Japanese yen Average interest rates also correlate cross-sectionally with average currency returns (an aspect of the forward premium puzzle) We plot average excess returns against betas with a value-weighted currency-hedged world index 16

18 Figure 3 R 2 = 48%; Slope = 3.2% 17

19 Figure 4 18

20 Currency Returns in Equilibrium Overall, there exist differences in average realized currency returns that correlate with currency risks. However, these average realized returns have been modest particularly so in the case of the US dollar and the euro 19

21 Conditional Currency Risk Management The ability of interest differentials to predict excess currency returns is well known Forward premium puzzle for academics Carry trade for FX market participants Part of this ability comes from long-run average differences in interest rates and excess currency returns But part of it comes from common time-series variation in interest rates and excess currency returns Do temporary movements in interest rates predict similar movements in covariances of currencies with equities? Do currency hedgers take the opposite side of the carry trade? 20

22 The Super Carry Trade In fact, when the base currency is a reserve currency, RM demands reinforce the carry trade rather than offsetting it One way to see this is to introduce a synthetic carrytrade currency Long the three currencies with highest interest rates Short the three currencies with lowest interest rates The synthetic currency has negative RM demand on its own, but positive RM demand in combination with other currencies 21

23 22

24 How Much Is Volatility Reduced? Table 7 reports standard deviations for global equity and bond portfolios hedged in alternative ways Equity portfolios: Large volatility reductions from full hedging when base currency is a reserve currency, small reductions or even increases when base currency is commodity-dependent Further substantial volatility reductions from optimal unconditional hedging Little benefit from conditional hedging strategies Bond portfolios: Large volatility reductions from full hedging 23

25 Table 7 24

26 Currencies in the Financial Crisis Dollar falls on doubts for its safe-haven status. By Peter Garnham. The dollar suffered yesterday as coordinated action from global central banks to ease liquidity tension in the world's money markets dented its newly found status as a safe-haven currency. Analysts said the dollar had previously benefited as worries over the state of the global financial system heightened risk aversion, prompting US investors to repatriate funds that had been invested in global equities, while lower inflation expectations had supported demand for US bonds. "In a world where cross-border equity investing collapses and bond flows remain stable, there is a net inflow back into the dollar", said Michael Metcalfe of State Street Global Markets. However, analysts said the decision by global central banks to inject $180bn of emergency dollar liquidity into the market had helped boost risk appetite and damp demand for the dollar... The dollar's losses were largest against the high-yielding Australian and New Zealand dollars, which had been the worst hit among leading currencies during the recent market turmoil. Financial Times, September 19,

27 Currencies in the Financial Crisis Several aspects of the financial crisis are consistent with the message of our paper Strong US dollar Weak Australian dollar Failure of the carry trade as low-interest-rate funding currencies strengthened The major exception is the weakness of the euro Probably reflects the fiscal strain on the eurozone implied by the magnitude of the crisis Market lacked faith that eurozone institutions could handle Greece and other weak sovereigns 26

28 Open Questions Why are reserve currencies attractive stores of value for equity investors? Macroeconomic fundamentals, e.g. stable long-term inflation expectations which keep inflation procyclical (Campbell, Sunderam, and Viceira 2008) Financial fundamentals, e.g. liquidity provision Amplification as flight to quality creates endogenous negative correlation of currency and equity returns Will these correlations change? Concern about the risk of a dollar crisis if investors lose faith in the US fiscal position (Rogoff) Possibility that aggressive monetary policy will destabilize inflation expectations. 27

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