An excerpt from
FALL 2014
THE NEW RULES FOR
WHEN TO HEDGE
A CURRENCY
Collin Crownover, Global Head of Currency Management
How much higher can
the US dollar go? The
euro fall? The answer
may surprise you,
according to new research
from our currency team
that upends the classic
valuation formula­—and
gives global investors
a higher-precision tool
for protecting their
portfolios in today’s
fluid FX market.
Figure 1: Currency Hedge Ratios Reach Record Highs Across
Developed Markets
0.8
0.6
0.4
0.2
0.0
AUD
CAD
n High since 1998
CHF
EUR
GBP
JPY
NOK
SEK
SGD
USD
n 3m high
Source: State Street Global Markets as of September 2014.
Past performance is not a guarantee of future results.
For much of the past few years, hedging
certain currencies has become the financial
version of an uncontested layup. The
tremendous misvaluations evident across
many currencies were obvious signals of
when and in what direction to hedge, making
cost/benefit hedging decisions rather simple
for investors. On top of that, investors have
been taking advantage of the low interest
1
STATE STREET GLOBAL ADVISORS | IQ: FALL 2014 ISSUE EXCERPT
“Only when the tide goes
out do you discover who’s
been swimming naked.”
—Warren Buffet
WHEN TO HEDGE A CURRENCY
Why The Sudden Rise
In Hedging?
Figure 2: US Dollar Index (DXY)
March 31, 2011—October 20, 2014
90
+18%
86
One reason is that hedging costs have
diminished. The cost to hedge is based
on the interest rate differential between
currencies. However, since developed
markets currently have accommodative
monetary policies with low to zero interest
rates, the interest rate differential is
generally near zero and the cost to hedge
is greatly reduced.
82
78
74
70
Mar
2011
n High since 1998
Jan
2012
Nov
2012
Sep
2013
Sep
2014
n 3m high
Source: Bloomberg as of October 20, 2014.
Past performance is not a guarantee of future results.
The index returns are unmanaged and do not reflect the deduction of any fees or expenses. The index
returns reflect all items of income, gain and loss and the reinvestment of dividends and other income.
rates in today’s developed markets, which,
because of the way hedging costs are
calculated, have substantially reduced the
expense associated with currency hedging.
However, as strongly overvalued and
undervalued currencies start to mean revert,
the neon signs for when and how to hedge
are beginning to fade. Determining when
to hedge a currency has never been a purely
scientific affair, and as currency misvaluations
become less conspicuous, some investors
may elect to simply neglect hedging programs
altogether. But we think investors are better
served to continue hedging using dynamic
tools to manage currency risk.
At SSgA’s currency management team, we
recently asked ourselves, is there a better
way to model currency that might give
investors more precise tools for deciding when
and how to hedge? We have re-engineered
our own models and back-tested the results,
2
Out of 10 developed market currencies,
five have seen hedge ratios hit an all-time
high in the last three months (Figure 1).1
with surprising ramifications for some of the
most pressing questions in currency markets
today. As investors now ask, for example,
if the United States dollar still has legs, or if
there is more room to fall in the euro, we
find that the standard “fair value” currency
valuation model is not giving us the full story
and is, in many cases, actually giving us the
wrong story. We explain here why dynamically
hedging currency is so important, and how
our new model is better equipped to defend
against currency losses.
Currency volatility rose
51 percent from July
through September 2014.
STATE STREET GLOBAL ADVISORS | IQ: FALL 2014 ISSUE EXCERPT
Additionally, currency volatility has increased,
with the Deutsche Bank Currency Volatility
Index rising 51 percent, from 4.93 percent
on July 21 to 7.43 percent on September 30.
The dramatic appreciation in the US dollar
is driving much of the volatility (Figure 2).
For US-based investors in foreign assets,
appreciation of the US dollar, of course,
means a greater risk that they will pocket
less money after converting from foreign
currency back to dollars, driving increased
hedging of foreign currency.
Some of the hedging fever may also stem
from concerns about monetary policies
that intentionally devalue currencies.
As policymakers in underperforming,
deflationary economies resort to the jolt
that a currency devaluation can provide
(i.e., increasing demand for exports and
propping up inflation), investors seek to
hedge more to prevent losses.
But this heightened consciousness for
currency risk, and concomitant hedging,
may not last. Hedging is an essential
process—although not necessarily a core
competence—for investors wishing to
reduce currency losses that could undermine
foreign-denominated equity or fixed-income
performance. Calculating when the potential
WHEN TO HEDGE A CURRENCY
Figure 3: Declines in Eurozone Productivity Display Correlation with
EUR Depreciation
Even as first-year economics
students, we knew that
exchange rates depend
on more than inflation.
Relative Productivity
EUR /USD
1.6
-0.2
1.5
-0.6
1.4
-1.0
of those losses outweighs the cost of applying
the hedge is inherently difficult and
somewhat ambiguous work. To get around
that, standard hedging is often done rather
formulaically using the rule of thumb that
hedging 50 percent of foreign currency
exposure generally provides a reasonable
cost-benefit trade-off for most international
portfolios (although some countries, such
as the US, tend to hedge less). The more
dynamic hedging that we’re seeing a spike
in now—where investors take long-run,
tactical views on currency and tilt around
their strategic hedges accordingly—requires
a sharper eye for currency movement, and
as such is often only done if calls on a
currency are relatively straightforward. This
is why, for example, hedging against foreign
currency depreciation vis-à-vis a rising
dollar is playing out so strongly; the rise in
the US dollar was widely anticipated, given
the relative strength of US growth, the
decline in the US deficit and the reduction
in accommodative US monetary policy.
However, well-telegraphed, highly visible
currency trends are now shifting, begging
the question of whether investors will
continue to actively hedge currency exposure
once appropriate positioning isn’t so obvious.
Investors have seen several currencies get
back closer to what appears to be a natural
set point. This includes the significant fall
3
1.3
-1.4
1.2
-1.8
Jan
2008
— Relative Productivity
2009
2010
2011
2012
2013
Sep
2014
1.1
— EUR/USD
Source: EIU, WM Company as of September 30, 2014.
Past performance is not a guarantee of future results.
The correlation coefficient measures the strength and direction of a linear relationship between two variables.
It measures the degree to which the deviations of one variable from its mean are related to those of a different
variable from its respective mean.
in the Australian dollar in 2013, following
soaring altitudes against the US dollar in
2011 and 2012; the euro, which has fallen
off a cliff to such an extent that investors
are questioning if it can fall any further;
and the appreciation of the US dollar, with
some questioning how much steam is left
in its upward trajectory.
If currency misvaluations are less palpable,
investors may shun dynamic hedging and
potentially misread their hedging needs
due to a perceived lack of opportunity and
a too hands-off approach. But while we
think dynamic hedging is the best approach
for investors, having the right tools to
implement it is key. Indeed, when we took a
step back and looked at existing models that
STATE STREET GLOBAL ADVISORS | IQ: FALL 2014 ISSUE EXCERPT
investors typically use to value currency, we
realized that a new, finely tuned currency
valuation model provides more accurate—
and surprisingly different—recommendations
for hedge positioning.
In backtesting, the new model
improved annual hedging
returns from January 2000
to present by over 50 bp.
WHEN TO HEDGE A CURRENCY
Figure 4: Simulated New Model Additional Annualized Hedging Returns
Under- or
Spot,
Valuation—
Valuation—
Overvalued?—
Currency Pairs
October 1, 2014*
Old Model
New Model
New Model
Additional Hedging Returns
vs. Old Model
2000–2014 (bps/yr)
Additional Hedging Returns
vs. Simple 50% Foreign Assets
Hedged 2000–2014 (bps/yr)
AUD/USD
0.87 0.72
0.78Overvalued
69
EUR /USD
1.26
1.31
1.21Overvalued
-19**
136
GBP/USD
1.62
1.69
1.59Overvalued
50
180
USD/JPY 109.58 77.68
89.57Overvalued
124
217
67
10
USD/CNY
6.14
8.79
7.02Undervalued
201
Source: State Street Global Advisors, Bloomberg as of October 1, 2014.
*Past performance is not a guarantee of future results.
**The underperformance here primarily came in 2012-13, when the Fed’s balance sheet was expanding and the ECB’s was shrinking, temporarily putting upward pressure on EUR/USD.
Indeed, the new model has handily outperformed in 2014.
The simulated performance shown is not necessarily indicative of future performance, which could differ substantially. Please see the disclosure section for additional simulation information.
The information contained above is for illustrative purposes only.
The Old Rules
for When to Hedge
The existing, conventional way to value
currency uses purchasing power parity
(PPP), the theory being that the exchange
rate between two currencies must reflect
the same purchasing power. This methodology
is exemplified by the “Big Mac Index.”
Under the theory of PPP, if either two units
of Currency A or one unit of Currency B
can purchase a Big Mac, then the exchange
rate should be—or is fairly valued at—2 to
1. This method has worked fairly well in
the past to estimate fair values of currency
and to hedge against some of the larger
swings in currency. However, we have
always known that the PPP method is not
telling the whole story.
The PPP method, based on values of
goods, relies on price inflation as the sole
long-term driver of the exchange rate.
Even as first-year economics students, we
learned that exchange rates depend on
much more than inflation, but we did not
have consistent evidence of this until recent
history provided certain test cases.
First, starting in 2008, falling relative
productivity in the eurozone created a perfect
environment to look at how productivity and
4
currency intertwine (Figure 3). Second, the
commodity super cycle, with skyrocketing
price growth in commodities from the late
1990s through recent years, offered up a
study in how certain currencies—such as
the Australian dollar—would respond once
the tide shifted and commodity-related
growth slowed in Asia. These periods of
heightened currency shocks allowed us to
weed out evidence of other factors that drive
currency, and to home in on flaws in the
PPP model. As Warren Buffett put it, “Only
when the tide goes out do you discover
who’s been swimming naked.” Research
shows that there are other factors—namely
productivity growth and terms of trade—that
significantly impact a currency and should
be used to augment estimates of fair value.
The New Rules
Studies show that productivity growth is a
major determinant of a currency’s fair value
and should augment the traditional PPP
method of valuing currency. Countries with
more productivity draw in more foreign
investment, which pushes up the value
of local currency. Additionally, increased
productivity puts upward pressure on
wages, and as local citizens become
wealthier, they bid up the value of services
(i.e., nontradable goods where higher
STATE STREET GLOBAL ADVISORS | IQ: FALL 2014 ISSUE EXCERPT
pricing cannot be arbitraged back down).
This also drives the local currency higher
than PPP would suggest.
The other silent harbinger of currency
valuation surfaced by the research is terms
of trade—or the ratio of a country’s export
prices to its import prices. Terms of trade
is a way to view whether a country benefits
(positive terms of trade) or loses (negative
terms of trade) from trading. For example,
if a country receives less money for exports
(lower prices at home) while having to pay
more for imports (higher prices abroad);
this is a negative terms of trade shock.
However, if terms of trade increases—i.e.,
a country starts to receive more for exports
relative to what it is paying for imports—the
wealth of the local citizenry rises. Similar to
productivity, this prompts greater spending
on services (nontradables) and therefore
real (adjusted for inflation) exchange-rate
appreciation. Higher terms of trade also
enlarges a country’s national wealth, which
can stimulate capex and foreign investment,
further appreciating the local currency.
But, as noted, the existing PPP model
completely ignores these trends, placing all
its emphasis on inflation as the determinant
of a currency’s fair value. In the mechanics
to include productivity and terms of trade in
WHEN TO HEDGE A CURRENCY
Figure 5: MSCI Market Cap-Weighted Index of USD Returns and USD Fair Values
145
130
115
fair value calculations, we built a regression
model that includes both of these variables
to explain the movement in equilibrium real
exchange rates over the long term. Our
research indicates that relative productivity
(relPROD) is half as important as relative
inflation, and relative terms of trade (relToT)
is half as important as relative productivity.2
The formula is such:
100
85
70
Jan
1990
— USD Index Spot
1996
— USD Index PPP
2002
2008
Jul
2014
— USD Index Enhanced PPP
The resulting fair value is then used in
calculations to determine the misvaluation of
currency in the market. The optimal hedge
ratio for each currency pair is determined by
mean-variance optimization of a sample of
deviations from fair value to market value
to generate the best expected risk-adjusted
returns from a currency hedging strategy.3
Source: MSCI, State Street Global Advisors, WM Company as of July 31, 2014.
Past performance is not a guarantee of future results. The index returns are unmanaged and do not reflect the deduction
of any fees or expenses. The index returns reflect all items of income, gain and loss and the reinvestment of dividends and
other income.
Figure 6: Productivity as a Structural Driver of Exchange Rates
CNY /USD Real Exchange Rate (log)
CNY/USD Relative Productivity (log)
0.0
0.6
-0.2
0.5
-0.4
0.4
-0.6
0.3
-0.8
0.2
-1.0
0.1
-1.2
Jan
1991
1995
— CNY/USD Real Exchange Rate (log)
2000
2005
2009
— CNY / USD Relative Productivity (log)
Source: FactSet, DataStream as of June 30, 2014.
Past performance is not a guarantee of future results.
5
STATE STREET GLOBAL ADVISORS | IQ: FALL 2014 ISSUE EXCERPT
Jun
2014
0
Under the new model, the
dollar is almost 10% higher
than what’s calculated by the
old, and the euro probably
has even farther to fall.
The Results
When productivity and terms of trade are
included in estimates of fair value, it is
evident that PPP regularly misses the
mark in its pricing of currencies. When
testing historical data for hypothetical
portfolios, including 10 developed market
and 22 emerging market currencies,
hedging ratios under the new model improve
the information ratio for the majority of the
portfolios in the sample. According to SSgA
WHEN TO HEDGE A CURRENCY
Figure 7: Terms of Trade as a Structural Driver of Exchange Rates
AUD/USD Real Exchange Rate (log)
AUD/USD Relative Terms of Trade (log)
0.30
0.35
0.00
0.00
-0.30
-0.35
-0.60
-0.90
-0.70
Jan
2000
2003
n AUD/USD Real Exchange Rate (log)
2007
2010
Jun
2014
-1.01
n AUD/USD Relative Terms of Trade (log)
Source: FactSet, DataStream as of June 30, 2014.
Past performance is not a guarantee of future results.
research, this boosts the combined sample’s
annual hedging returns from January 2000
to present by over 50 bps and improves the
information ratio by about 0.3, compared to
the PPP model.
One striking example of the gravity of
productivity growth on currency valuation
is in the US. Despite steady US dollar
appreciation already since mid-2011,
relatively high US productivity suggests
that the US dollar should be even stronger
than conventional PPP valuation suggests.
This means that US investors may have
even more of a reason to hedge against US
dollar appreciation than PPP may imply.
Under the new model, the market value of
the US dollar is almost 10 percent higher
than what’s calculated by PPP.
Figure 5 shows the path of the US dollar,
alongside fair value estimates from the
standard PPP method and from the
enhanced methodology that accounts for
productivity and terms of trade. Note that
6
the new enhanced fair value estimate
is consistently higher from roughly the
early 1990s onward.
Given that the US Federal Reserve (the Fed)
has pumped money into the system via
quantitative easing since the financial crisis,
it’s not surprising that the US dollar has
taken some time before rallying. However,
now that the Fed has taken its foot off the
stimulus gas pedal, we are starting to
see the true US economic fundamentals
reflected in the dollar. The improving
economic environment in the US—and
the better productivity in the US versus
abroad—says that the dollar should
continue to appreciate more than is
currently positioned for by many investors.
In other examples, the estimate of fair
value for the Chinese yuan jumps about
20 percent if you include productivity,
as average productivity growth in China
outpaces emerging Asia as well as
developed nations.
STATE STREET GLOBAL ADVISORS | IQ: FALL 2014 ISSUE EXCERPT
In other examples, fair value
jumps about 20 percent for the
Chinese yuan and about 10
percent for the Australian dollar.
Figure 6 shows the relationship between
productivity and real exchange rates in
China. The chart displays that the two work
in lockstep; as productivity in China has
increased relative to the US dollar, the
equilibrium real exchange rate (CNY/USD)
has generally appreciated as well.
By contrast, research shows that the values
of the euro and the yen are much weaker
once you factor in the anemic productivity
growth in those countries. Given long-run
productivity declines in the eurozone, the
euro—despite how far it’s already fallen—
probably has even further to fall than
traditional fair value calculations tell us.
Figure 7 shows a similar role played by terms
of trade in Australia. As Australia’s terms
of trade improved relative to the US dollar
during the run-up of the commodity
super cycle, the real exchange rate for the
Australian versus the US dollar appreciated
roughly in tandem. But when that tide turned
and Asian demand for exports declined,
we could pinpoint just how much terms of
trade drove that initial appreciation—about
10 percent. Now, even though the super cycle
has faded, the traditional PPP model fails to
take into account that Australia still exports
a lot more than it imports, and its terms of
trade are still high. Given this large impact,
in our view, terms of trade has to be included
as a component of currency valuation for the
Australian dollar going forward.
WHEN TO HEDGE A CURRENCY
Implications
for Investors
PPP, one of the most widely used models
to value currency, can be enhanced by
placing importance on productivity and
terms of trade to judge the relative value
of one country’s currency versus another’s.
With mean reversion of currencies taking
shape, blurring the lines between fair
valuation and mispricing, it is all the more
crucial to view hedging with a more
powerful microscope.
Most people aren’t hedging for the fun of it;
they own foreign assets and need to make
sure that their returns are not stifled by
movements in foreign currency. For example,
in the last cycle of massive US dollar
appreciation (1995–2002), a US investor
in, for example, the MSCI All-World Index
could have made nearly 50 percent in returns
absent the effects of currency repatriation.
However, with currency conversion included,
that investor would have pocketed less than
10 percent if no steps to hedge that exposure
had been taken.
In today’s stock market, when equity
valuations are high, and starting to come
under pressure, it is especially important for
foreign asset investors to hedge currency
risk most effectively and minimize currency
losses on returns as much as possible.
Source: State Street Global Markets; data dating back
to 1998.
1
2
In the regression model included here (and according
to PPP), the spot rate divided by the relative consumer
price index (CPI, a measure of inflation) computes the
equilibrium real exchange rate (RER).
3
ean-variance optimization, also known as Modern
M
Portfolio Theory (MPT) is an asset management tool
used to optimize the balance between risk (the variance)
and return (the mean).
FOR INSITUTIONAL USE ONLY. Not for use with the public.
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advice and it should not be relied on as such. It should
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security. It does not take into account any investor’s particular
investment objectives, strategies, tax status or investment
horizon. You should consult your tax and financial advisor.
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The whole or any part of this work may not be reproduced,
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Currency Management through the period ended October 31,
2014 and are subject to change based on market and other
conditions. This document contains certain statements that
may be deemed forward-looking statements. Please note
that any such statements are not guarantees of any future
performance and actual results or developments may differ
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Currency Risk is a form of risk that arises from the change
in price of one currency against another. Whenever investors
or companies have assets or business operations across
national borders, they face currency risk if their positions are
not hedged.
Investing in foreign domiciled securities may involve risk of
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appropriate for all investors. Commodities investing entail
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due to wide range of factors. A few such factors include
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7
STATE STREET GLOBAL ADVISORS | IQ: FALL 2014 ISSUE EXCERPT
trends, commodity index volatility, international, economic
and political changes, change in interest and currency
exchange rates.
All the index performance results referred to are provided
exclusively for comparison purposes only. It should not
be assumed that they represent the performance of any
particular investment.
The simulated performance shown was created by SSgA
Currency Management. Fair values are computed for 10
Developed Market (DM) and 22 Emerging Market (EM)
currencies. The simulation is performed monthly, with
rebalances at month-end. The Benchmark Portfolio used
is the MSCI Country Index, 50% hedged to US dollars at all
times. Transaction costs of 2 bps are used (one-way). Annual
Total Factor Productivity growth rate data is sourced from
FactSet /EIU. If available, official quarterly terms of trade
data is sourced from FactSet or Datastream, else annual
EIU terms of trade data is used. The results shown do not
represent the results of actual trading using client assets but
were achieved by means of the retroactive application of a
model that was designed with the benefit of hindsight. The
simulated performance was compiled after the end of the
period depicted and does not represent the actual investment
decisions of the advisor. These results do not reflect the effect
of material economic and market factors
on decision-making.
The simulated performance data is reported on a gross of
fees basis, but net of administrative costs. Additional fees,
such as the advisory fee, would reduce the return. For
example, if an annualized gross return of 10% was achieved
over a 5-year period and a management fee of 1% per year
was charged and deducted annually, then the resulting return
would be reduced from 61% to 54%. The performance
includes the reinvestment of dividends and other corporate
earnings and is calculated in various currencies.
The simulated performance shown is not necessarily
indicative of future performance, which could differ
substantially.
The MSCI is a trademark of MSCI Inc.
Source: MSCI. The MSCI data is comprised of a custom index
calculated by MSCI for, and as requested by, SSgA. The MSCI
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