Foreign Exchange Market
The foreign exchange market is a global decentralized or over-the-counter market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspects of buying, selling and exchanging currencies at current or determined prices.
Currencies can boost returns — but they can also decimate portfolios if their risk is not carefully managed. We discuss why, where and how to hedge currency risk – and outline our approach in taking active foreign exchange (FX) risk.
FX Currencies
Currencies are complicated, and we believe that taking FX risk is not rewarded over the medium to long-term investment horizons of most investors. We generally see FX as a portfolio risk that needs careful assessment and management, rather than as an opportunity to generate additional returns. Why hedge? With no clear return benefit over time, the key aim for many long-term investors is to reduce volatility. Currency moves can greatly increase the volatility of portfolio holdings. This is particularly the case for low-yielding fixed income assets, as the green bars in Keeping a lid on volatility chart below show.
Key Highlights
The impact is less for equities relative to overall risk —yet still large. Currency risk adds significantly to overall portfolio volatility in eurozone and UK equities. The exception is Japan, because of the yen’s propensity to move in the opposite direction of the domestic stock market.
We suggest investors hedge most of their FX exposures in major developed markets (DM). We favor fully hedging fixed income allocations and leaving a portion of equity holdings unhedged, especially for European investors. We give our preferred hedge ratios for standard portfolios, and explain why we favor permanent hedges over dynamically trying to maintain a set level of FX exposures.
We see some room for taking FX risk in the short term, keeping in mind the liquid, 24-hour market is often the first to respond to unexpected events. We outline what we see as key drivers of currency moves: policies affecting interest rate differentials, investor sentiment and other technical factors, valuations and economic fundamentals. We conclude we currently have low conviction on most currencies.
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