Download The return of currency hedging

E TF
INVESTMENT
STR ATEGY &
INSIGHTS
The return of
currency hedging
FEB 2017
The expectation of renewed strength in the U.S. dollar is bringing currencies
back into focus. After a year of minor investor interest for U.S. investors, we
believe the question of whether to hedge FX1 exposures is going to be an
important one in 2017, like it was in 2015. Additionally, currency volatility has
been rising over recent years, increasing the need to actively manage
Authors
currency exposures.
Heidi Richardson
for U.S. ETFs
Maria Eugenia Heyaca
Investment Strategist for ETF
Investment Strategy & Insights
Figure 1: Currency volatility on the rise
Implied volatility
Head of Investment Strategy
15%
10
5
Summary
2014
Renewed strength in the dollar
has brought currency hedging
back into focus.
We expect the U.S. dollar to
post moderate gains over
the year.
Over the long term, FX hedging
should be a case by case
consideration with the potential
2015
2016
2017
3 month implied volatility – average of euro, yen and sterling vs. USD
Source: Thomson Reuters DataStream and BlackRock Investment Institute. January 13, 2017.
Currency hedging tools can be used for both tactical calls (outperformance
potential) and long-term strategic allocations (volatility management). In this
report, we look at considerations on both fronts: first, trying to address nearterm drivers of major currencies and then looking at guidelines regarding the
long-term case for currency hedging.
Figure 2: A strengthening greenback
Index level
for significant risk reduction.
100
95
90
85
80
75
70
2012
2013
2014
2015
2016
2017
U.S. trade-weighted dollar
iShares.com
Source: Thomson Reuters DataStream and BlackRock Investment Institute. January 13, 2017.
Notes: The trade-weighted dollar is a weighted average of the foreign exchange value of the U.S. dollar against a broad
group of major U.S. trading partners.
1
FX is a commonly used abbreviation for foreign exchange rate, the rate at which one currency can be exchanged for another.
Currency outlooks
Although currencies are difficult to time (currency
After a post-U.S. election rally, we see the U.S. dollar on
volatility is significant when viewed over shorter time
a slow appreciation path, driven by a better growth
periods), the table below offers some thoughts on what
outlook, a pick-up in inflation expectations and
we see as the main short-term drivers for a number of
anticipation of future Federal Reserve (Fed) interest
major currencies.
rate hikes.
Figure 3: Currency outlook table
Currency
View/Drivers
U.S. dollar
The trade-weighted dollar looks set to post a moderate rise on the back of better
growth and interest rate differentials.
Risks seem to be slightly tilted to the upside if the Fed moves faster than the
market expects.
Euro
We see the euro relatively flat in the near term, with some upside if the European
Central Bank were to appear more hawkish.
Japanese yen
The yen has already fallen notably over the widening U.S. yield advantage. This trend
could continue if the yield differential widens further, which is a possibility given the
Bank of Japan’s curve management introduced in 2016.
Pound sterling
We see a more stable path with perhaps some upside potential, as short positions
remain high and, once Article 50 is triggered, we could get some more clarity on what
“Brexit” will look like.
Canadian dollar
The Canadian dollar could see some weakness vs. the USD, on relatively slow growth,
and widening interest rate differentials. A pick-up in protectionist rhetoric in the U.S.
would also be a headwind.
Swiss franc
The Swiss franc looks mostly range bound for now, especially as the central bank
continues to work to prevent a significant CHF appreciation.
Australian dollar
Potential ratings reviews, China contagion and housing market adjustments are likely
to continue to pressure the Australian dollar.
Emerging market currencies
EM currencies have already adjusted significantly, especially post-U.S. election.
If we don’t see a follow-through with protectionist policies we could see some
upside—in particular for countries with trade surpluses with the U.S. (LatAm, Russia).
Protectionist measures would hurt Asian currencies and the Mexican peso.
Mexican peso
The path for the Mexican peso will continue to be dependent on U.S. policy
developments. We continue to expect weakness as uncertainty subsists, yet a benign
trade environment combined with higher U.S. spending could see a relief rally.
Still, domestic political uncertainty may put a cap on any significant short-term rally.
South Korean won
Yield differentials with the USD, an easing bias from the central bank and potential
contagion from yuan depreciation point to continued weakness in the South
Korean currency.
Source: BlackRock, January 2017.
To hedge or not to hedge
allocation. Historically, this is particularly true in
Because every international investment is also an
developed markets. In emerging markets, some
active currency decision, one should think of currency
currencies have shown a trend of continuous
hedging not just as a tactical tool, but also as a
devaluation, increasing the importance of FX hedging.
strategic one. Much has been written about the long
term optimal hedging ratio and benefits of hedging
(or not) currency exposures.
But from a risk perspective, hedging strategies can
significantly reduce portfolio risk over long periods of
time. This is all the more true when an equity market is
significantly positively correlated to its currency:3
Although there is no consensus on an optimal
approach, and the decision to hedge is dependent on
each investor’s risk appetite, cost of hedging, size of
•• When correlations are positive, currency hedging
improves Sharpe ratios. This is because the currency
foreign asset holdings, etc. we derive a number of
exposure heightens the volatility of the position; it is
helpful guidelines from our research. The key takeaway:
essentially a “return-free risk.”
FX hedging is not an all-or-nothing decision, and
looking at each currency separately may be the right
•• The opposite is true for currencies with negative
correlations. In these cases, the unhedged exposure
way to go about it.
to the equity market provides inherent diversification
From a return perspective, it is commonly accepted
to the position as equity and currencies move in
that major currencies tend to mean-revert 2 over the
disperse directions.
long term, limiting the return potential of any strategic
Figure 4: The impact of currency hedging on Sharpe ratios4
Canada volatility
Canada annual returns
6
+
4
2
Positive
equity/FX
correlation
=
-0.1%
10
7%
20%
10.0%
8
+
6
4
1.0%
Negative
equity/FX
correlation
=
15
Potential
diversification 10
16%
17%
Unhedged
Local
Switzerland Sharpe ratio
0.36
0.40
9%
5
Unhedged
Local
FX
Unhedged
Local
0
FX
0
Unhedged
Switzerland volatility
Unhedged
8.9%
Local
FX
0
12%
2
0.26
5
Switzerland annual returns
10
0.35
14%
15
Return-free
risk
Unhedged
FX
-2
Local
0
19%
20%
8.2% 8.0%
8
Local
10%
Canada Sharpe ratio
Source: BlackRock, Thomson Reuters DataStream, MSCI. Dec 31, 2016.
Notes: The Sharpe ratio is calculated using the 20-year average 3-month treasury bill. Annual returns were calculated with a 20-year compound annual growth rate.
2
Mean-reversion is a theory that prices and returns eventually move back toward their average.
3
Currency correlation describes the relationship between a currency and another variable.
4
A Sharpe Ratio is a measurement of risk-adjusted return, defined as the average return of an asset ahead of the risk-free rate per unit of total risk (standard deviation).
Figure 5:
Composition of DXY
Figure 6:
Composition of U.S. trade-weighted dollar
CNY
EUR
MXN
CAD
JPY
KRW
GBP
TWD
INR
CHF
EUR
JPY
GBP
CAD
SEK
CHF
0%
20
40
0%
60
10
20
30
Percent of composition
Percent of composition
Source: Federal Reserve, Thomson Reuters DataStream. January 13, 2017.
Notes: The currencies in figure 6 represent the top 10 weightings out of 26 U.S. trade partners.
Using the right index
Investors often use DXY5 as the reference index for
The two indices have widely different compositions
the U.S. dollar. Yet the composition of the index is
(see above) with the most significant discrepancy
very tilted towards only a small number of currencies.
being the absence of any EM representation in DXY,
In comparison, the trade-weighted dollar (a measure
when EMs represent over half of U.S. trade flow.
favored by the Fed) tracks the moves of the U.S.
dollar vs. the 26 largest U.S. trade partners.6
This can lead to different performance with key
implications for monetary policy, financial conditions
and overall currency considerations.
Conclusion
The expectation of a somewhat stronger dollar
real currency risk embedded in their portfolio. Given
brings back into focus the need to hedge currencies
the mean-reverting nature of major currencies, the
for USD-based investors. But, beyond the short-term
return upside may be limited, but the volatility
view, any investor with international holdings should
advantage can be substantial. Whether tactical or
consider the long term effect of currencies on their
strategic, this conversation is not going away.
portfolios and take a careful look to understand the
5
6
The DXY, the U.S. dollar index, is a measure of value of the U.S. dollar relative to some of the world’s major currencies (Eurozone, Japan, United Kingdom, Canada, Sweden, Switzerland).
The trade-weighted dollar is a weighted average of the foreign exchange value of the U.S. dollar against the currencies of 26 U.S. trade partners.
iShares offers a comprehensive currency hedged suite with two distinct types of solutions
Fully hedged
Adaptive hedged
If you are looking to capture shorter-term opportunities or simply mitigate
currency volatility
Global
Minimum Volatility
HACW Global
HACV Global
HAWX GlobaI ex U.S.
HEFV
HHYX Int’l High Yield Bonds
Single Country
HAUD Australia
DEFA
HEWC Canada
DEZU Europe
HEMV Emerging Markets
HEWG Germany
DEWJ Japan
HEUV Europe
HEWI
Int’l Developed
Regional
Italy
HEWJ Japan
HEWW Mexico
HEZU
The iShares Minimum
Volatility ETFs offer
Int’l Developed
diversified stock market
Int’l Developed Small-Cap exposure while seeking
to minimize the market’s
Emerging Markets
peaks and valleys.
Europe
HEUS
Europe Small-Cap
HEWL Switzerland
HEFA
HSCZ
HEEM
If you would rather not make
hedging decisions yourself
HJPX
JPX-Nikkei 400
HEWY South Korea
HEWP Spain
Int’l Developed
The iShares Adaptive
Hedged ETFs dynamically
adjust to changing currency
markets by employing
four currency indicators
to determine the level of
hedging (0 – 100%).
These funds are better
suited for longer-term
holdings.
HEWU United Kingdom
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