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Euro Currency Risk in Global Equities By Aaron Cantrell M ost institutional investors’ portfolios are exposed to the euro in a large way. As of November 2012, European Monetary Union countries represented 19.6% of global equity market capitalization in the MSCI All Country World Index-ex-US. That number was even higher in developed-only portfolios. Holding these equities without a currency hedge implies an exposure to the currency in an equal amount. With the ongoing sovereign debt crisis in the Eurozone, investors have had to consider more seriously the risks that this currency poses to their portfolios. Here are some reasons why investors ought to take a strategic position with regard to the Euro and consider hedging Euro risk. The first reason is the existential crisis facing the euro. The engineers of the European Monetary Union overlooked Europe’s failure to meet the criteria for healthy monetary union, most importantly a united fiscal system and comparable productivity levels. These issues were raised while the project was being prepared, and neglecting them has created the chaos of today. The structural deficits in southern Europe, diverging levels of productivity, severe trade imbalances between North and South, and the lack of fiscal consolidation make it hard to see a fix to the growing debt issue that does not include a Euro break-up. The second reason is that the euro has become very highly correlated with risky assets. This phenomenon is explored in our recent paper ‘Do currencies behave like risky assets?’ (September 2012). The effect is that the equity volatility is compounded by currency volatility: when European equities rise, so does the euro, and vice versa. In the absence of this correlation, currency could even be thought of as a diversifier; however, given this strong correlation (0.62 in the past three years,1 it severely amplifies the risk and volatility of the equity portfolio. A. Chart A illustrates that the euro has begun behaving like a risky asset. Chart B shows the volatility of Eurozone equities at differing levels of currency protection. A hedge ratio of zero means the investor experiences the volatility of both the equities and the currency; a hedge ratio of 100% means that the currency volatility has been fully removed. The blue line shows the experience of the past ten years, and the red line is the past five years. Over the past five years, volatility was elevated, but hedging currency exposure was able to eliminate more of that volatility than before. This is due to the correlation effect described above. Over the past five years, hedging euros alone would have eliminated 8.6 percentage points of volatility on the European equity portfolio, and would have meant 2.0 percentage points of volatility reduction on the whole foreign equity portfolio. 2 (Continued on page 9) 8 The TEXPERS ® Pension Observer Spring 2013 Euro Currency Risk in Global Markets By Aaron Cantrell (Continued from Page 8) The third reason to be concerned about euro exposure is that the nominal and real value of the US Dollar is at a historic low on a trade-weighted basis. Currency cycles tend to last from 5 to 15 years, and over the past decade the dollar’s weakening has contributed positive returns to unhedged international portfolios. A US Dollar reversion to fair value over the next few years in line with typical currency cycles would create losses in unhedged portfolios. Moreover, due to the role of the US Dollar as safe haven currency, stress in the asset markets leads the US Dollar to appreciate, compounding losses. Chart C shows the value of the US Dollar against foreign currencies on a trade-weighted basis. The existential crisis that faces the euro, the emergent correlation that the euro has with underlying risky assets, and the historically low value of the US Dollar today, along with investors’ typically large exposure to the Eurozone, together imply that the euro poses a grave risk to investors’ international portfolios. Responsible investors ought to consider mitigating or eliminating this currency risk in these uncertain times, and to evaluate doing so in light of the cash flow implications and modest costs of running a hedging program. Aaron Cantrell is a Research Analyst at Record Currency Management Inc., in Atlanta, Georgia. B. The existential crisis that faces the Euro, the emergent correlation that the Euro has with underlying risky assets, and the historically low value of the US Dollar today, along with investors’ typically large exposure to the Eurozone, together imply that the Euro poses a grave risk to investors’ international portfolios. C. The TEXPERS ® Pension Observer Spring 2013 9