Loving the alien: Strategic currency considerations
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Loving the alien: Strategic currency considerations

This paper explores the extent to which developed-market
currency exposures should form part of an investor’s strategic
asset allocation. The key consideration is how a currency
can diversify the rest of the portfolio, acting as a stabiliser in
times of stress. Some currencies are pro-cyclical, doing well
in times of economic expansion; thus, hedging exposures
to these currencies could be beneficial. Other currencies, in
contrast, earn their place in a portfolio due to their propensity
to rise during times of economic turbulence. We find a
modest exposure is sufficient: allocating around 20% of the
portfolio’s risk budget to these counter-cyclical currencies
provides diversification while keeping in check the risk that
currency movements might drive the overall portfolio return.

Investors are well versed in diversification, spreading their risk exposures across a wide range of investments. These exposures, offering returns at different times, then work to produce an overall return stream that is smoother than the underlying constituents. A particular challenge with casting the investment net wide is that many assets exist in different domiciles to that of the investor. Exposure to the currencies of these domiciles therefore enter the portfolio often as an afterthought.

 

The question then arises as to whether these foreign exchange exposures should be hedged or retained. On the one hand, these exposures are unintended and not expected to contribute materially to return (so: hedge); on the other, they are an additional source of risk and may be able to reduce volatility at the portfolio level (so: retain).

 

How do we approach this as a Solutions team? We start with a review of the importance of the currency decision for an investor’s returns, and contrast this with the observation that the hedging decision should have negligible long-run expected return. In the short run, however, the way a currency’s returns covary with asset returns is the key characteristic that determines how much of it should be retained rather than hedged. We apply this insight first to single-currency assets and then to portfolios, uncovering a simple risk-budgeting rule that works well across a wide range of portfolios and currencies.

Interested in learning more?

Download the full viewpoint to discover more.

 

20 Oktober 2022
Pallavi Yadav
Pallavi Yadav
Client Investment Manager
Lorenzo Garcia
Lorenzo Garcia
Head of Investment Solutions, EMEA & APAC
Stuart Jarvis
Stuart Jarvis
Investment Solutions Quantitative Research Director
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Loving the alien: Strategic currency considerations

Important Information

For use by professional clients and/or equivalent investor types in your jurisdiction (not to be used with or passed on to retail clients). This document is intended for informational purposes only and should not be considered representative of any particular investment. This should not be considered an offer or solicitation to buy or sell any securities or other financial instruments, or to provide investment advice or services. Investing involves risk including the risk of loss of principal. Your capital is at risk. Market risk may affect a single issuer, sector of the economy, industry or the market as a whole. The value of investments is not guaranteed, and therefore an investor may not get back the amount invested. International investing involves certain risks and volatility due to potential political, economic or currency fluctuations and different financial and accounting standards. The views expressed are as of the date given, may change as market or other conditions change and may differ from views expressed by other Columbia Threadneedle Investments (Columbia Threadneedle) associates or affiliates. Actual investments or investment decisions made by Columbia Threadneedle and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Information and opinions provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. This document and its contents have not been reviewed by any regulatory authority.

In EEA: Issued by Threadneedle Management Luxembourg S.A. registered with the Registre de Commerce et des Sociétés (Luxembourg), Registered No. B 110242, 44 rue de la Vallée, L-2661 Luxembourg, Grand Duchy of Luxembourg.
In the UK: Issued by Threadneedle Asset Management Limited. Registered in England and Wales, No. 573204. Registered Office: 78 Cannon Street, London EC4N 6AG, United Kingdom. Authorised and regulated in the UK by the Financial Conduct Authority.
In the Middle East: This document is distributed by Columbia Threadneedle Investments (ME) Limited, which is regulated by the Dubai Financial Services Authority (DFSA). For Distributors: This document is intended to provide distributors’ with information about Group products and services and is not for further distribution. For Institutional Clients: The information in this document is not intended as financial advice and is only intended for persons with appropriate investment knowledge and who meet the regulatory criteria to be classified as a Professional Client or Market Counterparties and no other Person should act upon it.
In Switzerland: Issued by Threadneedle Portfolio Services AG, Registered address: Claridenstrasse 41, 8002 Zurich, Switzerland.

 

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