The equity hedging decision: grouping currencies to simplify the process
Compared with fixed income, we think decisions about whether and how to manage currency exposure are more nuanced in the case of equities. We designed a currency grouping framework to help.
Base currency groupings
If left unhedged, the impact of a portfolio’s base currency on the foreign equity returns depends on two characteristics. The first is the volatility of the currency itself. The currency exposure has a volatility profile, and by investing in a foreign equity without hedging the currency, a domestic investor is exposed to that volatility in addition to the volatility of the underlying foreign investment.
The second characteristic is the correlation of the currency with the foreign equity. For instance, currencies that appreciate during risk-on periods will tend to be positively correlated with foreign equities, with both being driven higher by the same pro-risk dynamic. Conversely, defensive currencies will tend to be negatively correlated with global equities, as they will generally rally during the risk-off periods when global equities decline.
We can assign base currencies to one of four groupings based on these characteristics and what they imply for the currency impact and hedging process. The groupings, illustrated in Figure 4, include the following:
Dampening currencies are pro-risk in nature and show a positive correlation with foreign equities. By appreciating when foreign equity returns are positive and depreciating when foreign equity returns are negative, these currencies partially offset (dampen) the gains and losses (and therefore volatility) of the foreign equity allocation. The extent of this dampening is related to both the degree of correlation between the currency and the foreign equity, and the volatility of the currency itself. This group generally includes currencies of commodity-exporting countries and emerging markets. Examples include the Australian dollar, British pound, South Korean won and Canadian dollar.
Amplifying currencies are counter-risk in nature and show a negative correlation with foreign equities. By depreciating when foreign equity returns are positive and appreciating when foreign equity returns are negative, these base currencies partially increase (amplify) the gains and losses (and therefore volatility) of the foreign equity allocation. The extent of this amplification is related to both the degree of the correlation between the currency and the foreign equity, and the volatility of the currency itself. The US dollar and Japanese yen are in this group.
Managed currencies are, to varying extents, influenced more by the policymakers in a country than they are by markets. Typically, this management involves setting a specific band within which the currency can move. The realized and expected volatility of the currencies is typically very low, limiting their impact on the performance of the foreign equity. However, these currencies are subject to gap or jump risk — the potential for a market to move suddenly and significantly in price as a result not of market demand/supply but of a decision by the policymaker (central bank) to set the exchange rate higher. Specific examples in this group are the Chinese yuan and the Hong Kong dollar.
Noisy currencies are defined as having an impact on the performance of the foreign equity, though the extent and, importantly, the direction of this impact is unclear and fluctuating. These currencies introduce noise to the foreign equity allocation, though it is not clear whether this noise will dampen or amplify the equity return volatility, and therefore what effect hedging will have. The euro is an example of a currency in this group.