Download Euro Currency Risk in Global Equities

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