How to manage emerging market currency risk

Investing in emerging debt or equity markets is a prudent way of adding diversification to portfolios for institutional investors. Associated with investment in these assets is a currency exposure that should be wisely managed, rather than just naively assumed. In this article we look at the investment characteristics of this currency exposure and the spectrum of approaches to managing it.

Investment characteristics of emerging market currency While emerging markets are defined differently by different index providers, they do tend to have a large degree of overlap. The MSCI Emerging Markets Index currently incorporates 24 countries across Asia, EMEA, and Latin America. There are such large differences between the economies in this group that viewing their currencies as one block of like investments misses a lot of nuance. For example, Latin American currencies have been about 50% more volatile than Asian currencies on average over recent years.

A basket of emerging market currencies (equity cap weighted) is of moderate risk: about 6% annualised volatility versus the US dollar since 1995. Currencies of different regions diversify well and there are several Asian currencies with large weights that are managed to have low volatility by their central banks (particularly renminbi).

There appears to be a persistent excess return to many emerging market currencies that have higher yields. The rate of spot depreciation in these currencies does not keep pace with interest rate differentials (forward premiums) and this can be seen in emerging markets currency as a basket.

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