Bridging the FX gap — Strategies to Counter EM Currency Risk

In a world characterised by low returns, fund managers are increasingly seeking emerging market (EM) assets that hold higher growth potential than those found in developed economies.

While on one hand this is presenting unprecedented opportunities in ‘off-piste’ destinations, this approach is nonetheless creating a currency mismatch between the capital currency of the fund ― usually in US dollars ― and the currencies in which EM assets are traded.

This means that while an EM asset might be yielding returns of 10% per annum, for instance, the fact that it is priced in an EM currency, which is depreciating against the US dollar by 5% per year, means that returns are halved. Further, in cases where negative asset returns are experienced, this is worsened by local currency depreciation.

Hedging, therefore, becomes a valuable tool in managing currency risk and creating long-term value.

Considerations for developing a robust emerging market currency hedging strategy

Have a rationale
Fund managers should first consider whether to hedge at the portfolio level or at the individual asset level, and whether the purpose of exercise is to hedge cashflows from the asset or debt at the asset level. These decisions will, in turn, impact the choice of hedging instruments used.

Determine the expected asset valuation and a timeline
Once these have been ascertained, they must be matched to the values, tenors and timing of the hedging tools in order to deliver anticipated returns.

Ensure there are sufficient financial resources to settle FX hedging obligations
There is a risk that market movements in the value of the asset and the exchange rate of an EM currency could result in substantial cash requirements, depending on the hedging tool used for a particular transaction.

Consider highly rated counterparties to mitigate credit risk
This is particularly the case with long-dated hedges. It is noteworthy that the credit profile of both counterparties affects the credit limits and credit charges, which are usually incorporated into hedging transaction prices.
 

AUTHORS

Nick Angove, Director, FX Investor Sales, Global Markets, ANZ
Mark Harding, Head of FIG South East Asia, ANZ
Robert Tsang, Director, CIS FIG, ANZ

For any comments or feedback please contact the authors at GlobalFIGInsights@anz.com
 

PUBLISHED NOVEMBER 2016

For a full set of relevant disclosures, please visit the link below.

View disclosures