Managing foreign currencies in an investment portfolio

Research Insights – June 2020, LGT Economic Research

“There is no sphere of human thought in which it is easier to show superficial cleverness and the appearance of superior wisdom than in discussing questions of currency and exchange.”

Winston Churchill Front cover: King and Queen and mixed currency on the chess board, shutterstock.com

Contents

4 Executive summary

5 Introduction

6 The hedging decision-making process

20 Current and future challenges for foreign currency management

22 The next safe haven currencies

26 Appendix 4

Executive summary

Investing in foreign assets is inextricably linked to investing in Similarly, if a portfolio’s base currency is considered a safe haven, foreign currency. The latter can lead to a dramatically different like e.g. the Swiss Franc that tends to appreciate when risk investment outcome between foreign and domestic investors assets sell-off, hedging (almost) all foreign currency exposure that buy the same asset. Not only will their returns differ, but is likely to be beneficial. This is because the portfolio’s assets their investment risk will too. Global investors will therefore will co-move with the foreign currencies associated with those have to decide how to deal with foreign currency exposure in an assets and thus add risk. On the other hand, if an investor’s base investment portfolio. currency is pro-cyclical and thus shows a positive correlation to global risk assets, having up to 40% foreign currency exposure By hedging currency risk, the foreign investment’s volatility will actually reduces risk. This is because it will give exposure to approximate the risk profile of the asset in domestic currency. save haven currencies (primarily USD given the high share of However, doing so will require the investor to forego the return USD-denominated assets in global benchmarks). on the foreign money market for their domestic money market rate, which can come at a cost or a benefit, depending on the From a cyclical perspective, hedging has a particularly strong sign of the two money markets’ interest differential. impact during times of economic crisis such as the current global recession induced by the spreading of COVID-19 as asset Conditional on how one thinks about the risk-return profile of price correlations become more aligned. Going forward, it may currency, one will thus tackle the hedging question differently. be desirable to tilt hedging ratios to the higher end of the usual Unsurprisingly, neither practitioners nor academics are therefore range for a variety of reasons such as a high volatility and low unanimous on how to manage currencies in a portfolio. Some return environment, prevalence of unconventional monetary argue that currencies do not earn a reliable risk premium but policy or the prospects of sustained lower hedging costs. only feature volatility. An unhedged asset will thus have the same risk premium as a hedged investment, but with higher In cycles to come, potentially novel safe havens should be volatility (i.e. a lower risk-adjusted return). Others find that if considered in the hedging process. Currently, there are three currencies and asset-prices tend to mean-revert, hedging may globally established safe haven currencies: USD, CHF and not reduce, or worse, even increase volatility in the long-term JPY. Our macro criteria-based catalogue identifies additional and result in higher transaction costs. currencies that may develop similar anti-cyclical properties in the more distant future. Viable candidates range from various We argue that the optimal way to deal with foreign currency Gulf currencies to prominent Asian and European currencies. in a portfolio changes with the underlying asset-currency Although it remains doubtful that the identified currencies will correlation and will thus vary across portfolios and base become global safe havens anytime soon, most of them have currencies. Generally speaking, low volatility assets should already served as regional ones in the past. Global investors have a high hedge ratio. For multi-asset portfolios that include can put such information to good use when setting up their alternative investments, somewhat higher hedge ratios appear portfolio hedges by taking selective exposure to regional safe adequate too. havens in the context of broader asset allocation. 5

Introduction

Investing in foreign assets is inextricably linked to investing argue that currencies do not earn a reliable risk premium but in foreign currency. For example, a US investor that buys a only feature volatility.1 An unhedged asset will thus have the European stock will earn a return that is composed of the same risk premium as a hedged investment, but with higher return of the euro-denominated stock plus the change in the volatility (i.e. a lower risk-adjusted return). Others find that EUR/USD exchange rate. Therefore, investing abroad means if currencies and asset-prices tend to mean-revert, hedging having exposure to two different sources of risk and return: may not reduce, or worse, even increase volatility in the long- the underlying asset and the exchange rate. Furthermore, the term and result in higher transaction costs.2 Others try to walk impact of the latter can be large. Consider the return of an the middle path and simply hedge half of their portfolio or identical global multi-asset portfolio for a Japanese investor and implement another universal hedge quota.3 Lastly, there are a British investor during the financial crisis in 2008 as shown in studies that find varying hedge ratios across base currencies Table 1. While the Japanese investor lost almost 40% in that optimal4, depending on the correlation between the asset at year, their British equivalent gained about 4% on the very same hand and the risk profile of the currency. portfolio. To some investors, foreign exchange is thus primarily a byproduct of international investing and an unwarranted Based on theoretical and empirical reflections, we tend to additional layer of risk. To others, it constitutes an extra source agree with the last lineage. Over the following pages, we will of return. However, to any investor, it poses a fundamental show what underpins our conclusion, give more insight on question: How to deal best with foreign currency in a portfolio? the key elements that shape our thinking about hedging and elaborate on how investors should take them into account when Indeed, there are quite a few important factors that shape making their own hedging decision. Specifically, we will explore the decision making process of an international investor. Most the mechanics behind hedging, outline the relevance of the importantly, the investment aim (return generation versus risk underlying asset’s volatility on the hedging decision and analyze reduction), the asset at hand, the investor’s base currency and how a portfolio’s base currency can lead to changes in the their investment horizon. Due to this variety of factors and optimal foreign currency exposure. We will then explore current preferences as well as conflicting aims that all influence the and upcoming challenges investors might face with regard to viability of hedging, neither practitioners nor academics are hedging and lastly, try to identify currencies that might gain in unanimous on how to manage currencies in a portfolio. Some relevance in the future for an investor’s hedging decision.

Table 1: Historical annual performance of a global mixed asset portfolio (60% equities/40% bonds) in various base currencies 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 p.a.

in USD 14% 10% -25% 19% 9% -3% 9% 10% 2% -3% 4% 16% -7% 17% 3.8%

in EUR 2% -1% -21% 16% 17% 1% 7% 5% 16% 8% 7% 1% -2% 19% 4.7% in GBP 0% 8% 4% 6% 13% -2% 4% 7% 8% 2% 24% 6% -1% 12% 6.7% in CHF 5% 2% -29% 16% -1% -2% 6% 7% 14% -3% 6% 11% -6% 15% 2.0% in JPY 15% 3% -39% 23% -5% -8% 22% 34% 16% -3% 1% 12% -9% 16% 3.4% in AUD 6% -1% -5% -8% -4% -3% 7% 27% 11% 9% 5% 7% 3% 17% 4.5% in KRW 5% 11% 1% 10% 6% -1% 1% 8% 6% 3% 7% 2% -3% 21% 5.4% in CNY 10% 3% -30% 19% 5% -7% 8% 7% 4% 1% 12% 8% -2% 18% 2.7% in SGD 5% 3% -25% 16% 0% -2% 2% 13% 7% 3% 6% 7% -5% 15% 2.6%

Source: Refinitiv, LGT Capital Partners

1 Cf. Perold and Schulman (1988) and Eun and Resnick (1988) 2 Cf. Froot (1993) 3 Black (1989) considers a universal hedge ratio of 77% appropriate in international equity portfolio whereas a 2004 survey by Russel/Mellon among institutional investors in major markets showed that the majority prefers to hedge in three distinct tranches, either zero, 50% or 100%. 4 Cf. Campbell et al. (2010) 6

The hedging decision-making process

Currency risk is not a new phenomenon. Although volatility was Although the mean-reversion argument is theoretically sound, generally lower in the past due to the gold standard, changes in practice, simply relying on PPP can be very risky. Numerous in gold supply or coinage devaluation could even then create assumptions underpinning PPP are not given in reality and fierce spikes in exchange rates. Since the prevalence of floating mean-reversion is often strenuously lengthy. For example, exchange rates, bursts of volatility have increased in frequency. the notoriously appreciating CHF has failed to mean-revert A few recent examples are the abandonment of the EUR/CHF to some measures of PPP-implied equilibrium values for more floor or the GBP slump following the Brexit referendum as well than 20 years. That’s a long period of continued exposure to as the 2019 Argentine peso sell-off. This tendency of exchange currency volatility and skewed currency returns, even for long- rates to move rapidly and beyond what fundamentals imply (i.e. term investors. Moreover, risk perception is merely a snap- overshooting) has also been widely documented and thoroughly shot and subject to change. Take the EUR for example. Until researched in academia, for example by the German economist the financial crisis, the common currency was widely perceived Rüdiger Dornbusch5. Clearly, such volatile movements can ruin as the successor to the Deutsch Mark, a safe haven currency. an otherwise solid investment and are thus undesirable from However, as risk perception regarding the European periphery a risk perspective. Given this empirical evidence, why would started to shift, the EUR was sold off heavily. While timing these an investor not want to protect their portfolio from currency abrupt, yet massive shifts in correlations is inherently difficult, fluctuations? implications on unhedged portfolio returns can be profound. For similar reasons, the argument that the downtrend in foreign The flipside of the coin is the so-called mean-reversion exchange volatility over the recent years reduces the need for tendency of real exchange rates. Standard economic theory hedging is flawed. A quick glance at Graph 1 clarifies that the postulates that the exchange rate between two countries current downtrend is neither unprecedented nor irreversible and should be a function of their relative price levels, a concept should thus not be extrapolated as we will explain in more detail known as purchasing power parity (PPP). If PPP holds, arbitrage in the third chapter. opportunities will force exchange rates to mean-revert. Consequentially, real exchange rates should remain roughly For a long-term investor, a successful approach to hedging constant over time. Thus over the long-term, the real value of should thus help free-up risk budget, which may consequently a foreign currency denominated investment measured in the be more effectively allocated, possibly in return-generating asset investor’s home currency will eventually be restored. Adding a classes other than currency. This does not rule out the ability hedge on top of this investment would result in either a loss or of FX to improve a portfolio’s return. It could simply suggest a gain, depending on the sign of the temporary fluctuation of that instead of having natural FX exposure from an unhedged the real exchange rate (i.e. appreciation or depreciation) from benchmark, the investor favors directional views and selective parity or put differently, it would increase volatility. Moreover, currency exposure. Consequently, such investors should focus the hedge will also introduce “unnecessary” transaction costs their hedging decision on the risk rather than the return impact and counterparty risk. of currency initially and add back foreign exchange exposure at a later stage in the investment process.

Graph 1: 1m realized volatility of daily FX returns (annualized) 40% 35% 30% 25% 20% 15% 10% 5% 0% 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012 2017

USD/AUD USD/CAD USD/CHF USD/EUR USD/GBP USD/JPY USD/SGD Median daily FX volatility Post Bretton Woods historic average Source: Refinitiv, LGT Capital Partners

5 cf. Expectations and Exchange Rate Dynamics (1976). 7

How hedging works position in the foreign money market. Depending on the interest The idea behind hedging is to protect the portfolio from swings rate differential between the two monetary areas, the investor in the exchange rate. To understand the impact of hedging, first will either earn or pay that carry. look at the components of an unhedged return. Consider a USD investor that wants to buy a EUR-denominated stock. The overall investment’s return7 is the following: ƒ The investor must first exchange USD for EUR at the t t tw t prevailing EUR/USDt exchange rate. t t ƒ Then, they will use the exchanged EUR amount to buy the stock. The above equation states that one can only hedge the ƒ After some time, e.g. one month, the investor decides to sell expected return, not the realized return. This is because at the the stock again and convert the proceeds back into USD at end of the investment period, the amount in EUR is usually the then prevailing exchange rate. larger or smaller than the hedged amount (because the asset has gained or lost in value), i.e. the position is under- or At the end of the investment period, the investor’s return6 will overhedged and a gain or loss is realized, also known as residual be as follows: currency exposure.

To clarify, let us consider a EUR 5m investment for a USD TheyReturn will in thus USD roughly (unhedged)≈Local earn the sum return+currency of the return in returnlocal investor. The investment is perfectly hedged as long as the currency plus the change in the exchange rate. From a risk asset value is EUR 5m at the end of the investment horizon and perspective, the investment takes the following form: EUR 5m are sold forward at inception of the trade. However, if the asset value increases to 5.5m (a 10% gain in value), EUR t t w 500’000 are left unprotected from changes in the EUR/USD t 2 exchange rate. 2×σ ×w×σ ×ρ (1) with VAR denoting the variance, referring to the standard deviation, w to the percentage weight allocated to foreign The local return of a foreign asset is thus not investable for the σ currency (which is 1 if the investment is unhedged) and investor in general. Either the currency is not hedged and they referring to the correlation coefficient between the stock prices are exposed to exchange rate risk or the currency is hedged and ρ in EUR and the EUR/USD exchange rate. Foreign currency they pay hedge costs and are still exposed to a residual currency exposure will thus generally add to the total risk of the portfolio, risk. The quality of the hedge is thus bound to the predictability unless the currency is sufficiently negatively correlated with the of the underlying asset’s return, which itself depends on factors asset. Hedging means to protect against this additional risk such as the investment horizon, volatility etc. Nevertheless, in component. If the investor does not want to bear the currency contrast to the unhedged investment, the risk incurred by the volatility, they can make use of a variety of instruments to investor will generally be closer to the asset’s standard deviation protect themselves. Typical hedging strategies involve entering a in local currency since the currency return and the forward currency forward contract or a currency swap, buying a futures return can be expected to mitigate each other. contract or using an option-based approach. These instruments differ somewhat with respect to standardization, exchange of Graph 2: Average return and volatility of a hedged and cash flow streams or costs, but broadly attain the same goal. unhedged stock investment for a USD investor in Europe 20% We will now review the investment, however, this time the 16% investor will fully hedge the currency risk by entering a forward 12% rate agreement at the beginning of the investment period. 8% 4% Doing so allows the investor to buy or sell a certain amount of 0% currency in the future at a price that is set today, which is also Return Standard deviation known as the forward rate. Conceptually, the investor enters MSCI EMU in EUR MSCI EMU in USD (hedged) a long position in the domestic money market and a short MSCI EMU in USD (unhedged) Source: Refinitiv, LGT Capital Partners 6 Consult the Appendix for the mathematical derivation. 7 Consult the Appendix for the mathematical derivation. 8

Graph 2 shows the investment discussed above with the On the other hand, a USD investor investing in e.g. German effective yearly price return and volatility that an investor bunds had earned a positive yield by hedging the investment would have faced on average between 2010 and 2019. As back to USD since the positive EUR/USD interest differential is explained above, while the average return between the hedged added to the bond’s yield. investment and the local currency return in EUR differ due to the FX carry return and the residual currency exposure, risk Historically, the cost argument has been even more prohibitive measured in the form of volatility is basically identical due to the when it comes to interest rate differentials relative to emerging hedge. market currencies as they are usually higher yielding and therefore an attractive source of carry. Moreover, forward The cost of hedging implied interest rate differentials tend to fluctuate more heavily It becomes evident from the above section that the level of the in emerging markets (EM) given a higher counterparty risk. So domestic interest rate relative to the foreign interest rate (the even if at the inception date hedging EM currency exposure FX carry) is a main contributor to the overall hedged return. seems justifiable, it may well be the case that a spike in the For a currency with a comparably lower domestic interest rate interest rate differential will prevent the investor from rolling the relative to the foreign market, hedging can therefore become contract over in the near future. It is self-evident that the cost quite costly in the sense that it is a drag on returns. Including argument becomes particularly drastic if an investor’s domestic the negative carry that one must bear, there are three (potential) currency is a notorious low yielder such as the JPY. cost factors related to hedging: ƒ The interest rate differential between the two currencies Graph 4: Historical interest rate differentials9 versus USD ƒ The cross-currency basis Developed markets: ƒ The bid-ask spread of the instrument 10%

5% The differential, also known as carry, can act either as a cost or a gain8. Think of a EUR investor that wanted to invest in USD 0%

bonds to profit from higher USD yields at the beginning of -5% 2019. The investor could expect to earn about 1.5% yield on -10% the investment but had to take an annual EUR/USD volatility

of roughly 10% into account. A high carry can therefore be 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 AUD-USD CAD-USD CHF-USD EUR-USD a strong argument to leave a position unhedged. The picture GBP-USD JPY-USD NOK-USD NZD-USD changes drastically if the investor had wanted to hedge the SEK-USD SGD-USD Median currency risk. Due to the then large interest rate differential Emerging markets: between the US and the Eurozone of roughly 3%, the investor 30% had no longer earned a positive yield (cf. Graph 3). 20%

10% Graph 3: Hedged bond yields from a USD and EUR perspective 0% 3.0% 2.5% -10% 2.0%

1.5% 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 1.0% BRL-USD CNY-USD 0.5% INR-USD KRW-USD 0.0% PLN-USD RUB-USD (NDF) -0.5% TRY-USD (truncated) ZAR-USD IDR-USD (truncated) THB-USD (truncated) -1.0% MXN-USD USD GBP JPY EUR CHF Median Source: Refinitiv, LGT Capital Partners USD investor (non-USD markets hedged to USD) EUR investor (non-EUR markets hedged to EUR) Source: Refinitiv, LGT Capital Partners

8 The underlying assumption here is that uncovered interest rate parity does not hold. 9 Based on 1m forwards, shown as 12m moving averages. 9

The second cost factor, the cross-currency basis, can be thought characteristics across stocks, bonds and multi-asset portfolios, of as a price for counterparty credit risk in freely traded markets. each asset class requires its own careful assessment when it We know from the concept of covered interest rate parity (cf. comes to hedging, as we are now going to demonstrate. Appendix) that the USD investor that sells EUR forward should earn the interest rate differential between the two currencies Hedging across different asset classes in return. However, in reality, the difference in interest rate In brief, the underlying asset class matters for your hedging is adjusted for risk. This risk adjustment is called the cross- decision. Over the course of a market cycle, both returns and currency basis. It is a function of supply-demand imbalances for volatility are typically larger for stocks than for bonds. Therefore, hedging and inadequate capital behind currency arbitrages and the same currency movement will have a disproportionally usually more pronounced during stress periods. For instance, bigger impact on the performance (in terms of both risk and at the height of the euro crisis 2011/2012, investors sought return) of a global bond portfolio than of a global equity to sell the EUR against the USD in the forward market, driving portfolio. This is confirmed in Graph 6 that shows a split-up of a notable wedge between the forward implied interest rate the volatility of global equity and bond indices into contributions differential (i.e. hedging costs) and the three months deposit from asset volatility and from currency fluctuations for different rate differential (i.e. money market difference). Therefore, the base currencies measured over monthly returns between 2004- cross-currency basis acts as a separate cost of hedging. 2019. While the contribution of currency fluctuations to total volatility is low and for some base currencies even negative, FX volatility accounts for more than half of the risk in a global bond Graph 5: Cross-currency basis portfolio. To put this into perspective, if history is any guide, the 3% 0.5% 2% USD fluctuates versus the EUR by roughly 10% per year. That 1% 0.0% 0% is twice as much as US government bonds fluctuate, however -1% -0.5% only half as much as the US stock market does. Therefore, fixed -2% -1.0% -3% income portfolio risk can be substantially reduced by hedging -4% -1.5% currencies. 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 Implied cross-currency basis (rhs) EURUSD 3m forward implied difference EURUSD 3m deposit rate difference Graph 6: Asset and FX risk experienced across base currencies Global stock portfolio (MSCI ACWI) Source: Refinitiv, LGT Capital Partners 20% 15% The third cost factor, the bid-ask spread, matters in the 10% sense that that hedging requires additional transactions (i.e. 5% the purchase and rolling-over of the forward contract) and 0% thus causes additional transaction costs in the form of the -5% USD EUR CHF JPY KRW AUD GBP CNY SGD bid-ask spread of the currency forward contracts. Although a Global bond portfolio (JPM GBI Global Index) comparably small cost, the bid-ask spread will act as a drag on 12% the portfolio’s performance relative to the unhedged position 10% when cumulated over time. In addition, the spread usually 8% 6% widens during periods of stress, as market liquidity decreases 4% or around seasonally important dates such as toward the end 2% 0% of the year. Moreover, traditionally less liquid currencies, such USD EUR CHF JPY KRW AUD GBP CNY SGD as emerging market currencies, also have large spreads and are Global multi-asset portfolio (60/40) therefore more costly to hedge. 14% 12% 10% 8% In conclusion, hedging high yielding and/or illiquid currencies 6% can become quite costly for investors and creates a trade-off 4% 2% between incurring the cost and reducing portfolio volatility. For 0% hedging to remain a viable strategy, risk-averse investors will -2% USD EUR CHF JPY KRW AUD GBP CNY SGD want to find a suitable balance or in optimum, reduce risk and Contribution of currency Contribution of assets improve returns simultaneously. Due to different risk-return Source: Refinitiv, LGT Capital Partners 10

The picture is less obvious for equity and multi-asset portfolios volatility of the currency (the denominator), the smaller the due to the correlation term between stocks and currencies. optimal weight and thus, the impact of the foreign currency exposure on total risk. However, if the currency is negatively By taking the first derivative with respect to w in equation correlated with the asset (i.e. <0), the optimal amount of (1), we can interpret this interplay between underlying asset foreign currency exposure is higher as it helps to diversify total ρ volatility and currency mathematically: risk.

t σ In� fact, w now describes =–ρ σ the theoretically (2) “optimal” foreign currency exposure that minimizes total volatility of an unhedged investment. For positive correlation coefficients p, the larger the inherent volatility of the asset (numerator) relative to the

Table 2: Difference in total risk between a hedged and an unhedged foreign asset investment for a given currency volatility of 10%

Asset volatility 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0% 20.0% 22.0% 24.0% 26.0% 1.0 -10.0% -10.0% -10.0% -10.0% -10.0% -10.0% -10.0% -10.0% -10.0% -10.0% -10.0% -10.0% -10.0% 0.9 -9.8% -9.7% -9.6% -9.5% -9.5% -9.4% -9.4% -9.4% -9.3% -9.3% -9.3% -9.3% -9.3% 0.8 -9.7% -9.4% -9.2% -9.1% -9.0% -8.9% -8.8% -8.7% -8.7% -8.6% -8.6% -8.6% -8.5% 0.7 -9.5% -9.1% -8.8% -8.6% -8.4% -8.3% -8.2% -8.1% -8.0% -7.9% -7.9% -7.8% -7.8% 0.6 -9.3% -8.8% -8.4% -8.1% -7.9% -7.7% -7.5% -7.4% -7.3% -7.2% -7.1% -7.0% -7.0% 0.5 -9.1% -8.5% -8.0% -7.6% -7.3% -7.1% -6.9% -6.7% -6.6% -6.5% -6.4% -6.3% -6.2% 0.4 -9.0% -8.2% -7.6% -7.1% -6.7% -6.4% -6.2% -6.0% -5.8% -5.7% -5.6% -5.5% -5.4%

0.3 -8.8% -7.8% -7.1% -6.6% -6.1% -5.8% -5.5% -5.3% -5.1% -4.9% -4.8% -4.6% -4.5% Hedging lowers risk 0.2 -8.6% -7.5% -6.6% -6.0% -5.5% -5.1% -4.8% -4.5% -4.3% -4.1% -3.9% -3.8% -3.7% 0.1 -8.4% -7.1% -6.2% -5.4% -4.8% -4.4% -4.0% -3.7% -3.4% -3.2% -3.1% -2.9% -2.8% 0.0 -8.2% -6.8% -5.7% -4.8% -4.1% -3.6% -3.2% -2.9% -2.6% -2.4% -2.2% -2.0% -1.9% -0.1 -8.0% -6.4% -5.1% -4.2% -3.4% -2.8% -2.4% -2.0% -1.7% -1.4% -1.2% -1.1% -0.9% -0.2 -7.8% -6.0% -4.6% -3.5% -2.6% -2.0% -1.5% -1.1% -0.8% -0.5% -0.3% -0.1% 0.1% -0.3 -7.6% -5.6% -4.0% -2.8% -1.8% -1.1% -0.6% -0.1% 0.2% 0.5% 0.7% 0.9% 1.1%

Correlation between asset and currency Correlation -0.4 -7.4% -5.2% -3.4% -2.0% -1.0% -0.2% 0.4% 0.9% 1.3% 1.6% 1.8% 2.0% 2.2% -0.5 -7.2% -4.7% -2.7% -1.2% 0.0% 0.9% 1.5% 2.0% 2.4% 2.7% 2.9% 3.1% 3.3% -0.6 -6.9% -4.2% -2.0% -0.2% 1.1% 2.0% 2.7% 3.2% 3.6% 3.9% 4.1% 4.3% 4.5% -0.7 -6.7% -3.7% -1.2% 0.8% 2.3% 3.3% 4.0% 4.5% 4.9% 5.2% 5.4% 5.6% 5.7% Hedging increases risk Hedging increases -0.8 -6.5% -3.2% -0.3% 2.0% 3.7% 4.8% 5.5% 6.0% 6.3% 6.6% 6.8% 6.9% 7.0% -0.9 -6.2% -2.6% 0.7% 3.5% 5.5% 6.7% 7.4% 7.8% 8.0% 8.2% 8.3% 8.4% 8.5% -1.0 -6.0% -2.0% 2.0% 6.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0% 20.0% 22.0% 24.0% 26.0%

Multi-asset Multi-asset More bonds More equity (incl. alternatives) (traditional only)

Source: LaBarge et al., LGT Capital Partners 11

In general, the higher the asset-to-currency volatility ratio, the portfolios that range somewhere in the middle between a pure more important the correlation coefficient for the total risk. stock and a pure bond portfolio, hedging reduces portfolio Using again equation (1) and assuming currency volatility of volatility as long as the asset-currency correlation stays above 10%, we can illustrate the interaction between various degrees -0.5. On the common assumption that the successful inclusion of asset volatility and currency-asset correlation in more detail. of alternative assets increases portfolio diversification and Table 2 shows the difference in total portfolio volatility between reduces inherent volatility, multi-asset portfolios that include a hedged and an unhedged investment in foreign assets with alternatives should consequently benefit from less foreign varying volatility and currency-asset correlations. A reading of currency exposure, i.e. a higher hedge quota. 0% implies an unhedged portfolio has the same volatility as its hedged counterpart. The table also denotes that if a currency In short, any hedging decision must reflect the currency- is perfectly correlated with asset risk, it is best to fully hedge asset correlation. The more negative the correlation between currency risk (thus, portfolio volatility is reduced by the total assets and currencies, the higher the likelihood that hedging is 10% that FX would introduce). On the other hand, if currencies counterproductive. What is important to keep in mind is that and assets are perfectly negatively correlated, portfolios with a a global portfolio has numerous asset-currency correlations volatility in excess of 5% can reduce risk by holding unhedged that may either enforce or offset total portfolio volatility. In currency exposure. consequence, simply using the stylized approach shown in Table 2 to find the optimal foreign currency exposure would These findings do not shift much if we adjust the currency likely result in suboptimal currency management. In the next volatility. For an imposed FX volatility of 10%, hedging helps to section, we will therefore analyze what currencies international reduce total risk in roughly 75% of all constellations. This figure investors are typically exposed to and show how the cyclicality rises to about 80% if the currency volatility is set to 20% and of their base currency will affect the hedging decision in a multi- decreases to 65% if currency volatility is calibrated at 5%. asset portfolio based on global stocks and bonds.

If we assume that a typical pure bond portfolio has roughly Hedging across different base currencies 6% volatility, whereas a typical pure stock portfolio has about Unlike their investment strategy or their asset mix, investors 16% volatility, we notice that hedging the bond portfolio are usually not free to choose their domestic currency, as it is helps to reduce risk as long as the currency and the bonds confined to where someone does business or sets up residency. are not negatively correlated by more than -0.9. The same Given this constraint, it is imperative to examine the impact of comparison for the stock portfolio suggests that it is actually hedging across various home markets. counterproductive to fully hedge the portfolio, once the correlation falls below -0.4. For typical 60/40 multi-asset 12

Currency exposure of an international investor of 97% when they invest in the global index. On the other To understand the impact of FX fluctuations on portfolios with hand, a USD investor faces only 43% foreign currency exposure different base currencies, it is necessary to understand which due to the USD’s predominance in the index. The necessity currencies international investors are most frequently exposed of managing foreign currency is thus higher when the home to , i.e. what their passive or natural currency exposure is.10 market is small.11 Breaking down two widely used international investment benchmark indices, the MSCI All Country World Index and the Moreover, the correlation of one’s base currency with the USD J.P. Morgan Government Bond Index Global, presents a striking, is paramount. Cyclical currencies12, such as the Australian yet not particularly surprising picture. The by far most important dollar, tend to appreciate relative to the USD during times of currency in both indices is the USD, with a relative share of 57% accelerating global economic growth and depreciate during and 38%, respectively. Put differently, USD volatility is the single times of economic distress. Conversely, safe haven currencies13, most important FX risk that a non-USD global investor has to such as the CHF or the JPY, usually soften relative to the deal with and consequently, the relative interest differential Greenback if the global economy is benign but rally during versus the USD is the prime cost or carry contributor to the episodes of faltering activity. This is also evident from our hedging decision. Consider a CHF investor for example, CHF introductory example on page 3. In 2008, a JPY investor lost denominated stocks are a mere 3% of the global index. This roughly 30% on his international multi-asset portfolio, as the means that a Swiss investor attains a foreign currency exposure JPY appreciated due to the unfolding financial crisis, while asset

Graph 7: Currency decomposition of prominent global stock and bond indices

Global stock portfolio (MSCI ACWI) Global bond portfolio (JPM GBI Global) Global multi-asset portfolio (60/40) BRL (1%) AUD (2%) CHF (2%) TWD (1%) CAD (1%) MXN (1%) HKD (2%) KRW (2%) CAD (2%) BRL (1%) KRW (1%) AUD (1%) IDR (1%) Rest (7%) Rest (7%) AUD (2%) KRW (2%) Rest (4%) CHF (3%) GBP (6%) CAD (3%) HKD (3%) USD (38%) GBP (5%) USD (50%) GBP (5%) JPY (19%) JPY (7%) JPY (12%) USD (57%)

EUR (9%) EUR (16%) EUR (27%)

Source: Refinitiv, LGT Capital Partners

10 For the sake of simplicity, we ignore potential hedging efforts of revenues at the company level which would require disentanglement to have accurate FX exposure as well as geographical distribution of revenues (e.g. a large international company listed in Switzerland that earns the majority of revenues in USD shows up as a CHF earning firm in the index decomposition). 11 To reduce the financial burden of hedging such a large exposure, investors in smaller markets sometimes prefer to have a dedicated home bias in their asset allocation. 12 Readers are referred to the subchapter on Cyclicality of currencies in the Appendix section for additional insight on how we identify cyclical and anti-cyclical currencies. 13 Safe haven currencies are in high demand during periods of uncertainty because they are perceived as less risky and tend to appreciate during episodes of market and economic stress. 13

prices fell. A GBP investor, on the other hand, merely 3%. equities is presumably positive and hence, a USD investor should Having established the typical currency exposure of global most likely (fully) hedge currency risk. The same argument is investors and the cyclicality of the currencies they are exposed applicable to other traditional safe havens, such as the CHF or to, we can now again use equation (2) to explain why the the JPY, that are negatively correlated with the USD. optimal amount of hedging differs across base currencies. Investors that allocate according to global benchmarks load a So far, we have theoretically assessed that hedging can be costly, considerable amount of USD denominated assets onto their but also very successful in reducing total risk, particularly for portfolios. Since the USD is a safe haven currency, its correlation foreign assets with low expected returns. For assets with higher with global equities has been negative on average. In line with inherent volatility, the picture has been less clear cut. However, the reasoning presented in the previous chapter, a portfolio with there appears to be a theoretical argument for higher hedging a negative asset-currency correlation held by a non-USD investor quotas in portfolios with anti-cyclical base currencies. The next should not be fully hedged but could actually profit from the section will now bring all these factors together by contrasting unhedged USD exposure due to the currency’s diversifying returns and volatilities across portfolios in nine different base effects. Conversely, a USD investor’s foreign currency exposure currencies. As a result, we can then identify how foreign will be dominated by a mixture of more risky currencies, such as currency is best dealt with in each of these portfolios based on the EUR or the GBP. Therefore, the correlation coefficient with empirical analysis.

Graph 8: Schematic risk reducing impact of hedging a stock portfolio depending on the cyclicality of an investor’s natural currency exposure

10.0% 8.0% 6.0% 4.0% 2.0% Hedging increases risk 0.0% Hedging lowers risk -2.0% -4.0% unhedged portfolio -6.0% Change in volatility relative to -8.0% Portfolio exposed to Portfolio exposed to safe haven currencies cyclical currencies -10.0% -1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0

Currency-asset correlation Source: LaBarge et al., LGT Capital Partners 14

Optimal hedge ratios across assets and currencies ƒ Money market overlay (MMO): The departing point of this In the following pages, we present the findings of our analysis approach is a fully hedged portfolio. On top of that, a long- of hedged versus unhedged portfolios. Specifically, we show short money market trade is added, where the portfolio’s how hedging affects portfolio risk and return and identify base currency is the short-leg and the USD (or any other optimal hedge ratios from a risk and from a return perspective foreign currency of interest) is the long-leg. In the table across pure bonds, pure stocks and multi-asset portfolios. Our below, a value of 100% will again represent a fully hedged analysis comprises nine different base currencies. Our sample portfolio. If we add a 20% long-short trade (i.e. an outright ranges from 2004 to 2019 and is based on monthly returns. We USD quota of 20%), the table will read 80%, i.e. the share of compute hedge returns according to the formula shown in the domestic currency left in the portfolio.15 Appendix section, using 1-month forward rates as instruments. Indices used are the MSCI All Country World Index14 and the J.P. The CSC approach is relatively standard and fairly easy to Morgan Government Bond Index. For multi-asset portfolios, two implement. What is intriguing about the MMO way is that it basic approaches to hedging have been examined. provides greater flexibility to react directly to rising or falling ƒ Combined share classes (CSC): This approach simply shifts the USD hedging costs (i.e. the single most important currency for hedge ratio of a global 60/40 multi-asset portfolio between 0 global investors) or other portfolio relevant currencies.16 (unhedged) and 100 (fully hedged). Think of an investor that combines hedged and unhedged share classes of a global multi-asset portfolio.

Table 3: Optimal hedge ratios across assets and currencies (2004 – 2019) USD CHF JPY CNY AUD EUR GBP KRW SGD Optimal hedge ratio for lowest volatility Multi-Asset: MMO 100% 80% 100% 50% 65% 70% 70% 65% 40% Multi-Asset: CSC 100% 85% 100% 80% 60% 60% 70% 60% 5% Equities 100% 85% 100% 70% 20% 40% 40% 35% 0% Bonds 100% 95% 80% 100% 100% 100% 100% 100% 100% Optimal hedge ratio for highest return Multi-Asset: MMO 100% 20% 0% 50% 40% 0% 0% 60% 50% Multi-Asset: CSC 100% 40% 0% 100% 50% 0% 0% 45% 100% Equities 100% 25% 0% 100% 50% 0% 0% 35% 100% Bonds 100% 50% 0% 100% 50% 0% 0% 100% 100%

Table 4: Risk and return impact of optimal hedge ratios USD CHF JPY CNY AUD EUR GBP KRW SGD versus unhedged portfolios (2004 – 2019) Optimally hedged – unhedged volatility Multi-Asset: MMO 0.0% -3.8% -5.8% -0.2% -4.1% -2.5% -2.2% -3.0% -0.3% Multi-Asset: CSC -2.2% -2.2% -5.8% -2.0% -2.1% -0.7% -1.6% -1.7% 0.0% Equities -2.1% -1.4% -6.1% -1.9% -0.2% -0.1% -0.3% -0.2% 0.0% Bonds -3.1% -5.1% -3.6% -2.9% -8.4% -4.5% -6.4% -7.4% -2.4% Optimally hedged – unhedged returns Multi-Asset: MMO 0.4% -1.1% 1.0% 1.1% -0.7% -1.4% 0.8% 0.3% Multi-Asset: CSC 0.5% 0.2% -1.0% 1.5% 1.1% -0.6% -1.5% 0.3% 0.1% Equities 0.3% 0.2% -1.0% 1.3% 0.4% -0.2% -0.8% 0.1% 0.0% Bonds 0.6% 0.9% -0.8% 1.7% 2.8% -0.4% -1.3% 1.3% 1.7%

Source: LGT Capital Partners

14 Due to the lack of data availability, hedged equity returns are based on the price index. 15 We chose to use an inverse reading to make the displayed optimal hedge ratios of the two approaches comparable. That way, a value of 100% will correspond to a completely hedged portfolio in the combined share classes and the money market overlay approach. 16 Note that, except for USD, our analysis does not allow for negative hedge ratios, i.e. seeking active currency exposure beyond the natural exposure associated with unhedged indices. Anecdotally, negative hedging would be appropriate for pro-cyclical currencies that tend to move in line with equity markets. We also do not impose certain minimum allocations to an investor’s home currency as is often the case in practice due to liquidity needs. Doing so could however reduce the optimal amount of unhedged currency exposure considerably. For example, a SGD investor is most likely unwilling to hold 95% foreign currency, (or 60% outright USD exposure) as outlined in Table 3. Although this is the amount of foreign currency that would have minimized overall portfolio volatility over the whole sample period in the absence of these restrictions. 15

Before we discuss multi-asset portfolios separately in the next Crisis of 2008, which is a consequence of our sample range section, we first want to highlight the high optimal hedge ratio starting only in 2004. for bond portfolios across all base currencies. In line with the theoretical arguments presented above, it is highly desirable to When it comes to attaining higher returns, the picture is more fully hedge fixed income portfolios from a risk perspective. In dispersed. AUD investors could have improved their average addition, in analogy to our discussions of the impact of hedging return by roughly 1.1 percentage points by holding an optimally on asset classes, the findings are less homogenous for pure hedged portfolio relative to holding an unhedged global stock portfolios. Portfolios with anti-cyclical base currencies tend portfolio. KRW investors would have also attained higher to exhibit less volatility at higher hedge ratios (i.e. less foreign average returns from holding a minimum volatility portfolio. currency exposure) and vice versa for more cyclical-currencies. This is due to the fact that both currencies were roughly What is also evident from Table 3 is that the reduction in risk is unchanged relative to the USD over the sample period, but the usually comparably large relative to the reduction in return in carry was positive. EUR and GBP investors would have received bond portfolios, while less so in stock portfolios. lower returns from holding currency in a way that minimizes portfolio volatility. This is owed to the cost of hedging and Lastly, notice how the results also indicate that the popular their currencies’ relative performance to the USD. The former strategy of simply hedging half of the portfolio would have was higher for EUR investors, while the latter mattered more resulted in a suboptimal allocation over the sample period. for the GBP investor as the pound depreciated relative to the Moreover, the marked dispersion of optimal quotas across base Greenback over the sample period. In the case of the SGD, currencies are at odds with applying a universal hedge ratio in returns were highest when the portfolio was almost completely the spirit of Black (1989). hedged. Interest rates in Singapore are determined by the global level since the MAS targets an undisclosed basket of the Optimal hedge ratios of pro-cyclical currencies (AUD, EUR, currencies rather than a policy interest rate. As such, hedging GBP, KRW, SGD) costs are generally closer to US levels. Given the MAS induced Multi-asset portfolios with a pro-cyclical base currency can appreciation of the SGD path (which resulted in lower returns have between 30% – 40% foreign currency exposure/USD on foreign currency denominated assets) and relatively low exposure to reduce portfolio risk optimally according to our hedge costs, returns were generally higher when the portfolio 2004 – 2019 sample data. For these currencies, completely was fully hedged. hedging amounts to removing safe haven currencies that can provide diversification benefits. Having more or less than the Optimal hedge ratios of anti-cyclical currencies (USD, CHF, recommended amount of FX would have resulted in increased JPY, CNY) portfolio risk. The only notable exception is the Singapore dollar, Safe haven currencies should have less foreign currency where investors are best advised to leave the portfolio roughly exposure than cyclical currencies. This is intuitively clear since unhedged (i.e. hold foreign currency) or add as much as 60% the global investor with a safe haven base currency is likely to outright USD risk, respectively.17 This is likely a consequence incur a loss on their investment (i.e. the equity-driven multi-asset of the Monetary Authority of Singapore’s (MAS) managed portfolio) as well as on the depreciation of the asset’s currency float regime. Compared to other cyclical currencies, the SGD relative to the safe haven currency during times of market is generally less volatile. Therefore, currency risk measured in distress. From a risk reduction perspective, portfolios with a safe terms of standard deviation is generally lower too and holding haven base currency are advised to hedge at least 80% of their USD does not contribute as much to total portfolio volatility as foreign currency exposure based on these findings. USD and in other portfolios with cyclical base currencies. Accordingly, JPY investors are even better off by fully hedging the portfolio. the benefits to diversification from holding foreign currency In a CHF portfolio, it is advisable to have around 15% foreign are larger.18 The optimal hedge ratio for the EUR is in line with currency exposure. A CNY portfolio should not have more than the currency’s cyclical nature observed since the Great Financial 20%, but could do with more USDs.19

17 See also footnote 16, where we explain why we caution against implementing this finding in a portfolio. 18 However, the implicit risk taken by the investor (which is not reflected in the standard deviation) is that the MAS will at some point stop managing/not be able to manage the currency and volatility will spike massively. In practice, holding such a large amount of unhedged currency exposure is therefore not a recommended strategy. 19 The situation of the CNY is similar to the SGD since the currency is also managed against a basket of currencies including the USD. Between China’s WTO entry in the early 2000s and 2014, the currency appreciated nearly 40% against the USD and ca. 33% on a trade-weighted basis. After China started its domestic deleveraging campaign, the CNY fell more slowly compared to other EM currencies versus the USD and continued to appreciate on a trade-weighted basis trade-weighted basis, which helps to explain the difference between the two hedging approaches. For additional information see also footnote 26. 16

From a return perspective, completely hedged USD investors did stock and multi-asset portfolios due to the higher volatility of not face a trade-off as a fully hedged portfolio featured also the stocks and consequently higher importance of stock market – highest return on average. Similarly, CNY investors could also exchange rate correlations. This is likely why simply hedging half profit to some extent from higher returns and lower volatility of the portfolio results in suboptimal currency allocation. when hedging the foreign exchange exposure. The result is rather bleak for JPY investors. Their costs of hedging weighed Moreover, again in analogy to theory, differences in the on the portfolio’s return. The result of the CHF seems peculiar underlying asset-FX correlation (i.e. the cyclical nature of a at first, given the currency’s traditionally low yields (i.e. high cost currency) results in differing optimal hedge ratios. If their of hedging). However, CHF had been appreciating relative to domestic currency is pro-cyclical, we find that risk-minimizing USD over the whole sample by more than average hedging costs global investors would find it beneficial to have up to 40% were. Therefore, CHF investors would have had lost more on unhedged currency exposure. The AUD, GBP, EUR, KRW and their unhedged global exposure than on the hedge costs they SGD belong to this currency type. Conversely, investors with a paid. Consequently, hedging reduced risk and slightly improved safe haven home currency should have higher hedge ratios. JPY returns for CHF investors in the sample. In addition, the de-facto or USD investors should consider a fully hedged portfolio, as peg of CHF between 2011–2015 has likely limited the amount their base currencies tend to appreciate in times of economic of CHF’s appreciation, without it, the risk-return trade-off may distress, leaving them with a negative return contribution of have been even more appealing. their foreign currency denominated asset and an additional negative effect from exchange rate movements. CNY and CHF Synopsis of empirical results investors should have no more than 20% and 15% unhedged In line with our theoretical derivations, the above empirical currency exposure, respectively. results confirm that investors that hold assets with relatively low expected returns and comparably low volatility, such as Having established the viability of using different hedging bonds, are well advised to fully hedge their exposure from a risk quotas across different base currencies, the next sections will perspective. Otherwise, currency volatility will likely dominate scrutinize the robustness of this conclusion by extending the overall portfolio volatility. On the other hand, holding a certain time horizons over which returns are hedged and by briefly amount of foreign exchange exposure can be of merit in some contrasting crisis and non-crisis periods. 17

Hedging across different time horizons longer stretches. However, the process takes often markedly As we have seen, in most multi-asset portfolios, hedging longer than PPP theory suggests (recall the CHF example at the currency does a good job at reducing total risk based on beginning), leaving unhedged returns exposed to a considerable monthly hedged returns. Does this also hold true when returns layer of currency volatility in-between.20 are hedged over longer stretches? Analyzing this question is imperative since some people argue that PPP serves as a The lengthy and uncertain process of mean-reversion suggests “natural hedge” for long-term investors. If this is the case, that a sound hedging strategy should pay-off relative to simply then the average portfolio volatility of hedged and unhedged relying on PPP in both the short- and long-run. Indeed, in our portfolios should even out over time. However, there are sample, volatility in most hedged portfolios remains lower some caveats to this strategy. Firstly, numerous theoretical relative to unhedged portfolios even as the time horizon assumptions related to absolute PPP theory, such as no increases. The finding holds in particular for hedged bond barriers to trade, consumption of identical baskets of goods, portfolios, as unhedged bonds feature less than half the no capital flows etc., are not given in practice, which means volatility of unhedged investments on average. While such a that the fair mean-reverting value is not readily observable but result could be biased due to our rather short-sample range must be estimated instead, resulting in a range of outcomes (2004–2019), we take comfort in the fact that a 2010 IMF and uncertainty around these estimates. Secondly, empirical working paper (cf. Schmittmann, 2010) using 35 years of data research on PPP is not entirely conclusive. There is little evidence came to a similar finding. As such, and based on the arguments that PPP holds in the short-run, but there is some consensus presented above, we are inclined to conclude that hedging is a that tendencies toward mean-reversion are observable over viable strategy for short- and long-term investors.

Graph 9: Ratio of hedged versus unhedged portfolio volatility over time 1.4 Hedging increases volatility

1.2

1

0.8

0.6

0.4

0.2

Hedging reduces volatility 0 s s s s s s s s s A A A A A A A A A ks ks ks ks ks ks ks ks ks d d d d d d d d d c c c c c c c c c n n n n n n M M n n n M M M M M M M o o o o o o o o o o o o o o o o o o t t t t t t t t t B B B B B B B B B S S S S S S S S S USD CHF JPY CNY AUD EUR GBP KRW SGD

1 Month 1 Quarter 1 Year 3 Years 5 Years Equal volatility Refinitiv, LGT Capital Partners

20 Estimated half-lives of adjustments to PPP range as widely as from below three to over ten years, depending on the approach used (cf. Taylor, 2004). 18

The impact during crises quota over the investment horizon. Put differently, static Looking at the evolution of risk over the sample since 2004 concepts assume that correlation, mean and variance remain in a 60/40 portfolio helps to illustrate the beneficial impact of unchanged over the investment horizon. The advantage of a optimal hedging further, as portfolio volatility is higher during static approach is that the amount of risk that can be shifted crises. to asset classes with more appealing risk-return characteristics ƒ Currency risk accentuates already heightened portfolio than currency is known at initiation. It can thus be incorporated volatility for a USD investor during crises. On the contrary, in in strategic asset allocation decisions. The obvious disadvantage a EUR portfolio, holding some unhedged foreign exchange is that keeping the hedge quota invariable does not keep exposure (i.e. primarily USD in our example) has a risk- costs constant, as interest rate differentials are not static. reducing impact during times of economic distress. Furthermore, the rolling of hedging contracts introduces market- ƒ The relative share of currency risk in total portfolio risk is also timing risks, e.g. if the hedge is rolled although the currency is large during non-crisis periods in a USD and EUR portfolio. about to bottom. An active hedging strategy tries to mitigate Hedging can thus have a meaningful risk reducing impact costs and negative cash flows from rolling contracts and during non-crisis times as well. generate positive returns by selectively changing the hedge quota across currencies based on market views.21 Academic Passive versus active and static versus dynamic hedging research has put emphasis on such dynamic hedging models The above findings are based on what is called static or that allow mean and covariance to be time-varying. However, passive hedging. In contrast to active hedging, where foreign these models are generally more complex and computationally exchange exposure is shifted dynamically in reaction to market intensive, which sometimes limits their applicability. developments, passive hedging does not change the hedge

Graph 10: The composition of portfolio risk during crises Global multi-asset portfolio (60/40) in USD Global multi-asset portfolio (60/40) in EUR 25% 20%

20% 15%

15% 10%

10% 5%

5% 0%

0% -5% Financial Eurozone Taper China 2018 No Total Financial Eurozone Taper China 2018 No Total crisis crisis tantrum growth year-end crisis crisis crisis tantrum growth year-end crisis jitters correction jitters correction

Contribution of asset volatility Contribution of FX volatility Contribution of asset volatility Contribution of FX volatility Source: Turnill et al., LGT Capital Partners

21 In contrast to an absolute currency return strategy however, returns are not measured against a zero benchmark, but against the portfolio’s natural FX exposure. 19 Eric Prouzet unsplash.com 20

Current and future challenges for foreign currency management

In our stylized multi-asset portfolios, we have identified Monetary policy: After a decade of unconventional monetary hedge ratios between 60% up to 100% as optimal for total policies, central banks may find it increasingly difficult to provide risk reduction, depending on the underlying cyclicality of the additional stimulus in downturns. This could put established currency and its interaction with the major asset risk contributor, correlation patterns into question and result in higher FX equity risk. However, the identified hedge ratios are based on volatility. Think of a Swiss National Bank that is at some point past correlations. While it is true that currencies can drift for a no longer able or willing to lean against CHF strength, as the long time, they will likely not do so indefinitely. In fact, shifts cost of pushing interest rates into even more negative territory in correlation regimes occur fast and unexpectedly, particularly and a ballooning balance sheet start to outweigh the economic if the economic cycle is stretched and susceptible to bouts disadvantages of a stronger currency. On the other hand, of volatility (i.e. late cycle stage).22 Given such potential for correlation patterns might perhaps shift even more drastically instability, cross-currency correlations may break down when if policy makers actually decide to go for another round of investors’ need for diversification is most dire. In the following monetary field experiments, e.g. in the form of helicopter section, we discuss several current and future developments money, responding to changes in nominal GDP or outright that explain why it may be advisable to have a tilt toward a high exchange rate targeting. hedge ratio going forward (at least in those markets, where costs permit so). The rise of crypto: Similarly, the rise of crypto currencies is a challenge to established fiat money and monetary institutions. Low return environment: In a low return environment, For a variety of reasons, Bitcoin & co. are rightfully still highly unhedged currency exposure increases the possibility of speculative and volatile assets. However, they could gain in dragging returns into negative territory on a portfolio of foreign investors’ appeal increasingly going forward. A broader shift assets, as excess returns provide a smaller cushion for added into crypto FX could prove to be at the detriment of established volatility of currency. Since expected returns are lower than in currencies, at least temporarily, as the market converges to a the past, the same amount of volatility from undesired currency new equilibrium. Despite being a transitory shock, this process risk has a disproportionally larger impact on the performance might take some time. In analogy, when the US abandoned as even a modest loss on the exchange rate can tilt a foreign USD convertibility to gold in 1971 and consequently ushered currency denominated global asset portfolio into losses. in the end of the Bretton Woods’s fixed exchange rate arrangement, it took until 1976 for the new regime of managed flexible exchange rates to be formally ratified in the Second Amendment to the Fund Agreement.

22 A 2010 IMF working paper on currency hedging by Schnittmann finds that currency-equity correlations can fluctuate as much as from +0.4 to -0.4 from one decade to another. 21

Renminbi internationalization: It is the outspoken aim of of unskilled labor. Lastly, the demographic dividend, particularly China to internationalize the CNY. Doing so demands that in more industrialized emerging economies in the Middle East market forces take a greater role in the determination of the or East Asia, has started to fade. A trend that is expected value of the currency and hence, less intervention and more to accelerate. While EM central banks are thus faced with a volatility, respectively. A more internationalized renminbi might strikingly disinflationary backdrop that requires lower rates, DM also eventually reduce reserve currency demand for the USD, central banks find it increasingly difficult to lower yields even EUR and other established reserve currencies, suggesting some further from current, often already negative, levels. As such, rate structural downward pressure on these latter. differentials/hedge costs should fall.

Falling hedging costs: Hedging costs for emerging market Wider availability of instruments at lower costs: Financial currencies are set to fall due to global disinflation. In most integration continues to expand the universe of hedgeable emerging markets, current inflation rates are at secular lows. currencies. According to the IMF’s Exchange Rate Arrangements As a consequence, central banks in developing nations have and Currency Convertibility Report in 2018, 140 of the 190 the unique chance to lower rates to previously unattainable members (ca. 74%) had functioning forward exchange markets. levels. It seems plausible that the interest rate differential That’s roughly a 7% increase since the end of the Great between emerging and advanced economies will narrow Financial Crisis in 2009. Moreover, as noted in a speech by Peter to the point where hedging these currencies is no longer Zöllner, Head of the Bank of International Settlements Banking excessively expensive. In fact, the disinflationary environment Department in 2014, search costs for counterparties, a key in emerging markets is likely to stay as technological progress feature of forward over-the-counter markets, are decreasing and efficiency gains in manufacturing reduce prices and the due to improvements in aggregation and algorithmic trading demand for commodity exports. Moreover, recent trends techniques. As technical progress continues, hedge costs are toward localization, repatriation of manufacturing to advanced likely to fall further, while the availability of hedging instruments economies and progress in robotics could increasingly weaken and hedgeable currencies continues to increase. growth and wages in emerging economies with a high share 22

The next safe haven currencies

Safe haven currencies are known to appreciate during episodes easily declared pro- or anti-cyclical and as previously outlined, of high market uncertainty because they are perceived as correlations are not static and neither is risk perception. From less risky. The lower risk perception is based on appealing a hedging perspective, it seems therefore desirable to explore institutional and macroeconomic fundamentals, as well as if there are other currencies that have the potential to become high liquidity. Currently, three currencies are considered safe safe havens. To identify potential candidates23, we have havens globally: the USD, the JPY and the CHF. Portfolios in compared 54 currencies with the characteristics of the CHF and base currencies of more cyclical nature profit from holding some the JPY.24 exposure to these currencies. However, not all currencies are

Table 5: Criteria catalogue for identification of safe haven currencies A positive net international investment position (NIIP): The net international investment position is the difference between foreign assets owned by citizens and domestic assets owned by foreigners. It measures external vulnerability. In times of rising uncertainty, foreign assets tend to be repatriated resulting in high demand for the domestic currency if foreign asset holdings are large. A positive basic balance The simple basic balance is the sum of a country’s current account and its net foreign direct investment. A positive basic balance amounts to having net trade and investment inflows and results in stable demand for a country’s domestic currency. Net government debt proxy (currency reserves minus government debt) Currency reserves are an efficient tool to preserve exchange rate stability by selling reserves against domestic currency. Moreover, they are also utilized to pay off a country’s debt burden. The difference of the two is used as an approximation to net government debt. Inflation deviation from target below 3% (in absolute terms) Inflation erodes the purchasing power of a currency over time. In order to prevent a difficult to manage situation of falling prices, some inflation is generally tolerated by central banks. A central bank that is skilled at managing inflation expectations and targeting inflation rates is thus supportive for the stability of the domestic currency. Fiscal balance above -3% of GDP Overstretched fiscal balances tend to increase debt levels and depreciate the domestic currency. The case of Japan shows, however, that high debt itself must not prevent a currency from becoming a safe haven. The focus should rather be on stabilizing debt. As countries tend to have positive long-term growth and inflation rates, they can in fact tolerate some overspending without endangering long-term debt stability. High political stability & absence of violence/terrorism War, revolution, violence and political turmoil are synonymous for instability, resource depletion and overspending. High political stability guarantees reliability and preserve faith in a country’s issuing entity. Countries must rank in the third tercile of all countries surveyed to fulfill the criteria.

Source: LGT Capital Partners

23 Our selection criteria are loosely based on the 2011 ECB working paper Getting Beyond Carry Trade: What Makes a Safe Haven Currency? as well as insights of our separate publication Are Western economies turning Japanese? 24 Although the USD does share certain qualities with the other two safe havens, its status as such is also strongly related to the Greenback’s dominance in global transactions: it accounts for over 40% of all daily foreign exchange transactions, a trait that is difficult to mimic. 23

Assessment of currencies introduces the high cyclicality of the commodity into the Out of the ten countries that fulfill the requirements shown in economy and bilateral exchange rates. Table 5, Botswana is perhaps the most surprising candidate. Generally not on the radar of the global investment community, This argument is also applicable to most of the oil-related the southern African country has been one of the fastest currencies, such as the Qatari or Saudi riyal, that our analysis growing economies on the continent in the last decade. The identifies. Although Gulf economies have been implementing Botswana pula is a fully convertible currency that is subject to structural reforms to diversify away from oil and gas, progress a crawling peg/band. The Bank of Botswana implements the has been slow. The United Arab Emirates is perhaps the most exchange rate regime by adjusting the trade-weighted nominal successful among them, although oil still accounts for just effective exchange rate (NEER) at a rate of crawl that follows the under 35% of GDP. Another hindrance for the Gulf currencies differential between the central banks inflation objective and to abandon their USD pegs and become safe havens is the the forecast inflation of trading partners. However, one of the region’s broader geopolitical instability. Although the United stumbling stones for the currency to become a safe haven is the Arab Emirates and Qatar are politically stable countries on a low diversification of the Botswanan economy, which is primarily standalone basis, geographical proximity to Iran and Yemen based on three pillars: diamonds, cattle raising and tourism. make them subject to the spillover of violence. For these World Bank data suggests that about 25% of GDP, 85% of currencies to develop safe haven qualities, regional tensions export earnings and roughly one third of government revenue must likely cease or at least stabilize lastingly. is accountable to diamond extraction. This interdependency

Table 6: Potential safe haven currencies (annual data as of 2019) Macro Technicals Official Forwards NIIP Basic reserves Fiscal Inflation Political FX available to (in balance -gover- balance Freely Commodity minus stability FX regime turnover/ non-do- % of (in % of nment (% of convertible? currency? target (0 – 100) liquidity mestic GDP) GDP) debt (% GDP) investors of GDP) Japan 54.9 3.1 -171.6 1.4 -4.4 82.2 free float yes very high yes - Switzerland 117.3 14.5 35.0 1.3 0.3 95.4 floor vs EUR yes very high yes - Botswana 56.5 8.7 42.7 1.9 -0.2 85.3 crawling peg yes low yes Diamonds managed CNY: NDF/ China 17.0 6.0 16.0 1.0 -1.1 28.0 float vs no very high - CNH: yes basket Czech Republic -33.6 2.9 8.1 0.7 -1.2 84.2 free float yes medium yes - pegged to Hong Kong 314.6 39.4 112.9 0.9 2.0 82.8 yes very high yes - USD Crude oil & Norway 167.1 12.3 -31.1 0.6 8.7 93.5 free float yes high yes gas pegged to Crude oil & Qatar 3.3 18.3 -4.4 0.7 6.6 86.0 yes medium yes USD gas pegged to Crude oil & Saudi Arabia 94.8 14.9 42.5 1.3 2.7 30.4 yes low yes USD gas managed Singapore 215.3 38.8 -19.5 1.4 4.3 95.0 float vs yes very high yes - basket

no (daily qualified Taiwan 162.7 8.1 48.0 2.2 -2.3 74.3 free float medium - limits) investors only

pegged to Crude oil & UAE 3.1 2.5 1.7 0.8 3.7 72.9 yes low yes USD gas

Source: Refinitiv, LGT Capital Partners 24

Among the Asian currencies, the Singapore and the Hong Kong dwindles, as both expenses and revenues are paid for and dollar are the two most promising safe haven cadets. Both earned in CNY akin to USD operations today or GBP operations economies have impeccable macro fundamentals and sound during the reign of the British Empire. However, before such technicals. However, both economies are strongly tied to global a tipping point comes about the renminbi must become truly trade flows, which limits the extent to which their economies internationalized first. Only when conversion is fully possible at and currencies can evolve orthogonally to global activity. any point in time, i.e. also during times of economic distress, will Moreover, Singapore has a long-standing policy of discouraging foreign companies become indifferent between leaving revenue the internationalization of the SGD, because the currency in CNY or exchanging it back to their home currency. Of course, is the principal tool of monetary policy. From a correlation this is also conditional on the broader continued successful perspective, the Hong Kong dollar naturally is the better safe transformation and opening-up of the Chinese economy. haven candidate of the two due to its peg to the USD. While the Currently, data are still reflective of investor restraint toward the peg is sound and has held firm during various financial market CNY as growth of spot, forward and option volumes continues crises, it seems plausible that it will be reshaped at some point. to lag relative to the emerging markets average (25% versus The economic proximity to China, a fast growing economy, 55% over the last three years). Moreover, political risk in China makes economic growth in Hong Kong outpace US growth. is still conceived as considerable. Both factors argue against the In the future, outsourcing monetary policy to the US (which is CNY becoming a safe haven in the nearer term. what the peg de facto does) may become too great of a cost in the form of too low interest rates and too high domestic The two European currencies with potential are the Norwegian debt build up. Moreover, a fully opened up Chinese capital krone (NOK) and the Czech koruna (CZK). For the past couple account could result in CNY being the major currency circulating of years, the NOK has been a typical commodity currency, with in Hong Kong’s system in the future. It may thus very well average rolling correlations between the oil price and the trade- become appropriate to shift the peg toward the CNY or a broad weighted NOK amounting to around 60% over a 1 to 5 year basket of currencies with corresponding changes in the HKD’s horizon. However, the Norwegian economy is more complex correlation patterns. Furthermore, current protest movements and diversified compared to the other oil exporting nations in Hong Kong are not yet reflected in the available data set on in our selection. Compared to GDP, oil exports are roughly political stability. Sustained political disquiet would certainly 22%. Unfortunately, economic interdependencies with the weigh on the currency’s safe haven appeal. rather cyclical economies of the euro area and Great Britain are immense (roughly 80% of total exports). As both crude oil and Regarding the Taiwan dollar as well as the Chinese renminbi, trade partners are rather cyclical in nature, the NOK could find both lack full convertibility as of today. In terms of cyclicality, it difficult to establish itself as a potential safe haven. Regarding Taiwan is a large-scale exporter of electronics like integrated the Czech koruna, it lacks the important feature of a positive circuits and semiconductors and thus eagerly following the net international investment position, which is primarily due high and low tide of global trade flows. Moreover, geostrategic to the large share of foreign direct investment into the country tensions in the Taiwan Strait are likely to remain elevated in in the past. Akin to Norway, although the Czech economy is the coming years. This limits the TWD’s safe haven potential. highly diversified, 87% of all exports are Europe-bound. What The Chinese renminbi, on the other hand, is a viable candidate additionally argues against the CZK becoming a safe haven is to become a global safe haven. China’s re-orientation from a that the currency might in fact cease to exist. Having signed the manufacturing to a consumption-driven economy will continue Treaty of Accession, the Czech Republic is ultimately required to reduce the country’s dependence on cyclical trade flows. to adopt the EUR once it satisfies the convergence criteria. Moreover, the sheer size of the Chinese economy and the Currently, such a fear is ill-placed as public opinion is decidedly concomitant desire to do business there guarantees strong against EUR adoption and joining the common currency area demand for the CNY. As international companies’ CNY has been postponed indefinitely. However, should Europe find a operations become an ever increasing share of total revenue, way to manage its structural challenges, a shift in public opinion the necessity for earnings conversion back to home currency in favor of joining the currency union seems conceivable. 25

Implications for hedging they may and sometimes already have served as safe havens In review, although many of the currencies identified hold for regional investors. For example, the Norwegian krone was appealing characteristics similar to established global safe in high demand during the euro crisis in 2011, as investors haven currencies, most have in some ways high exposure to the sought to re-allocate funds out of the euro. The Botswanan global cycle and less diversified export destinations compared pula was adapted alongside the USD and other currencies in to Switzerland and Japan. For the more exotic and less liquid Zimbabwe following the hyperinflation in the country. As for candidates such as the Botswanan pula, considerable progress the Hong Kong dollar, after Western countries introduced high- on the technical front is still required. More likely candidates level economic sanctions on Russia, oligarchs and high net are the two financial hubs Hong Kong and Singapore. Both worth individuals were said to have transferred funds into the currencies are highly liquid and internationally renowned. The USD-pegged currency to preserve purchasing power. Hong Kong dollar (as well as the Gulf currencies) may look like safe havens already due to their peg relative to the USD, but The major take-away for a global investor should be that safe they are not, as pegs may break. Consequentially, one might haven currencies are not static and not meant to last eternally, just own actual USD instead. The Singapore dollar too holds but they are considerably stable once they are established as attractive fundamentals, but current correlation patterns and such. Paying attention to one’s base currency and adjusting its highly cyclical economy diminish the currency’s safe haven a hedge ratio accordingly can spare trouble and help avoid potential. The same conclusion applies to the Norwegian krone. unnecessary costs. Moreover, keeping a close eye on the evolution of the risk characteristics and taking selective exposure While these currencies are therefore unlikely to rise to having to local safe haven flows can pay off handsomely in the context the same risk-off appeal from a global perspective as JPY or CHF, of broader asset allocation. 26

Appendix

Mathematical derivations Cyclicality of currencies Consider a USD investor that wants to buy a euro-denominated The following tables assess the cyclicality of currencies on an stock. Defining the spot rate as units of base/home currency (i.e. index and on a trade-weighted basis. The advantage of this USD) in one unit of the local currency (EUR), the return on their approach is that it singles out the actual average quarterly investment will be the following: correlation between 2004 and 2019 that an investor, who

invests in the global stock or bond market, faced given their tt t t tt t domestic currency. This equation can be re-arranged to yield: The more cyclical currencies are the AUD, EUR25, GBP and the t t t t t t KRW, while the USD and the JPY tend to be anti-cyclical. The Δ% Δ% Δ% CNY is somewhat anti-cyclical. Although the currency is not NowReturn consider in USD≈Local the same return+currency investment, but returnfully hedged (i.e. H=1). fully pegged, it is still managed26 against a basket of currencies For illustration purposes, a forward contract will be used. A including the USD. More surprisingly, the traditional safe haven forward contract allows the investor to buy or sell a certain CHF is only very weakly correlated with global stocks and bonds amount of currency in the future at a price that is set today. and the mathematical sign is counterintuitive. However, this is Given no arbitrage, the forward exchange rate equals the likely due to the fact that the CHF was de-facto pegged to the spot exchange rate adjusted for the interest rate differentials EUR between 2011 and 2015. between the two countries.

tt

Further, denote Stock as EQ, Δ%Stock as , EUR/USD as S %& ()* and Δ%EUR/USD as . The investment𝑅𝑅 "now#$ yields: 𝐹𝐹𝐹𝐹"#$ %& ()* 𝑅𝑅"#$ 𝐹𝐹𝐹𝐹"#$ 𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝐸𝐸 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸 𝑖𝑖𝑖𝑖 𝑈𝑈𝑈𝑈𝑈𝑈 𝐸𝐸𝐸𝐸𝑡𝑡+𝑖𝑖𝑖𝑖1 𝑈𝑈𝑈𝑈𝑈𝑈×𝑆𝑆𝑡𝑡+1 +𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝑡𝑡𝑡𝑡+1 ××𝑆𝑆𝐻𝐻𝑡𝑡+×1 +𝐹𝐹𝑡𝑡𝐸𝐸𝐸𝐸− 𝑆𝑆𝑡𝑡 𝑡𝑡+1 ×𝐻𝐻× 𝐹𝐹𝑡𝑡 − 𝑆𝑆𝑡𝑡+1 𝑡𝑡+1,ℎ𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑡𝑡+1,ℎ𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸 𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸 𝑅𝑅 = 𝑅𝑅 = 𝑡𝑡 𝑡𝑡 𝑡𝑡 −𝑡𝑡 1 − 1 𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸 𝐸𝐸𝐸𝐸 𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸×𝑆𝑆 𝐸𝐸𝐸𝐸 ×𝑆𝑆 𝐸𝐸𝐸𝐸𝑡𝑡+1 𝑆𝑆𝑡𝑡+1 𝐸𝐸𝐸𝐸𝑡𝑡+1 𝐹𝐹𝑡𝑡𝑆𝑆−𝑡𝑡+𝑆𝑆1𝑡𝑡+1 𝐹𝐹𝑡𝑡 − 𝑆𝑆𝑡𝑡+1 = 𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸 × =− 1 𝑖𝑖𝑖𝑖+ 𝐸𝐸𝐻𝐻𝐸𝐸𝐸𝐸×× − 1 + 𝐻𝐻× 𝐸𝐸𝐸𝐸𝑡𝑡 𝑆𝑆𝑡𝑡 𝐸𝐸𝐸𝐸𝑡𝑡 𝑆𝑆𝑆𝑆𝑡𝑡𝑡𝑡 𝑆𝑆𝑡𝑡 𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸 𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸 𝐹𝐹𝑡𝑡 𝑖𝑖𝑖𝑖− 𝐸𝐸𝑆𝑆𝐸𝐸𝐸𝐸𝑡𝑡+1 𝐹𝐹𝑡𝑡 − 𝑆𝑆𝑡𝑡+1 = 𝑅𝑅𝑡𝑡+1 + 𝐹𝐹𝑋𝑋𝑡𝑡+=1 𝑅𝑅1𝑡𝑡+1𝑅𝑅𝑡𝑡++1 𝐹𝐹𝑋𝑋𝑡𝑡++1𝐻𝐻1 ×+ 𝑅𝑅𝑡𝑡+1 + 𝐻𝐻 × 𝑆𝑆𝑡𝑡 𝑆𝑆𝑡𝑡 = 𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓=+𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒄𝒄 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓+ 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄+ 𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒄𝒄 𝒇𝒇𝒇𝒇𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒇𝒇 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓+ 𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓 𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸 𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸 𝐹𝐹𝑡𝑡 𝑖𝑖𝑖𝑖− 𝐸𝐸𝑆𝑆𝐸𝐸𝐸𝐸𝑡𝑡 𝑆𝑆𝑡𝑡+𝐹𝐹1𝑡𝑡 − 𝑆𝑆𝑡𝑡 𝑆𝑆𝑡𝑡+1 − 𝑆𝑆𝑡𝑡 = 𝑅𝑅𝑡𝑡+1 + 𝐹𝐹𝑋𝑋𝑡𝑡+=1 𝑅𝑅1𝑡𝑡+1𝑅𝑅𝑡𝑡++1 𝐹𝐹𝑋𝑋𝑡𝑡++1𝐻𝐻1 ×+ 𝑅𝑅𝑡𝑡+1 − +𝐻𝐻 𝐻𝐻× × − 𝐻𝐻 × 𝑆𝑆𝑡𝑡 𝑆𝑆𝑆𝑆𝑡𝑡 𝑡𝑡 𝑆𝑆𝑡𝑡 𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸 𝐹𝐹𝑡𝑡 −𝑖𝑖𝑖𝑖𝑆𝑆 𝐸𝐸𝑡𝑡𝐸𝐸𝐸𝐸 𝐹𝐹𝑡𝑡 − 𝑆𝑆𝑡𝑡 𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸 𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸 = 𝑅𝑅𝑡𝑡+1 + 𝐻𝐻 × = 𝑅𝑅𝑡𝑡+1 + +𝐹𝐹𝑋𝑋𝐻𝐻𝑡𝑡+ ×1× 1 + 𝑅𝑅𝑡𝑡++1𝐹𝐹𝑋𝑋𝑡𝑡+−1×𝐻𝐻 1 + 𝑅𝑅𝑡𝑡+1 − 𝐻𝐻 𝑆𝑆𝑡𝑡 𝑆𝑆𝑡𝑡 = 𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓=+𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑭𝑭𝑭𝑭 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒄𝒄 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓+ 𝑭𝑭𝑭𝑭+ 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒄𝒄𝒓𝒓 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄+ 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒄𝒄 𝒓𝒓𝒆𝒆𝒓𝒓𝒆𝒆𝒆𝒆𝒓𝒓𝒓𝒓𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆

25 Classifying the EUR as pro-cyclical is primarily based on its post Great Financial Crisis performance. Before 2008, most investors considered the EUR a successor of the Deutsch Mark and thus a safe haven. 26 The Chinese yuan is allowed to fluctuate within a controlled 2% band against an undisclosed basket of currencies during any given trading session. The mid-point rate for the trading band is announced daily by the country’s Foreign Exchange Trading Center and based on the onshore closing day of the previous trading day as well as on a mechanism known as counter-cyclical factor. The latter is said to take macroeconomic conditions and pro-cyclical market sentiments into account. 27

During this episode, the CHF was effectively constrained from Monetary Authority of Singapore (MAS) allows the SGD to strengthening, while yields fell globally following large-scale float within a band against an undisclosed basket of currencies unconventional easing efforts by global central banks. Thus, of major trading partners and competitors. Singapore’s main the correlation pattern with respect to stocks and bonds is trading partners are Hong Kong and China, both managed somewhat distorted. In fact, a separate correlation analysis and anti-cyclical currencies, as well as other Asian nations, between the trade-weighted exchange rate and global growth, whose currencies are typically more cyclical. Given its positive measured by the global manufacturing PMI, hints at the CHF’s correlation with equities and the countries strong links to global safe haven qualities. Another currency that is difficult to label trade, we eventually opted to label it a cyclical currency. with regard to its cyclicality is the Singapore dollar (SGD). The

Cyclical currencies Anti-cyclical currencies Table 7: Correlation between global stock market and KRW AUD GBP SGD EUR CHF CNY JPY USD index-weighted exchange rate 69% 65% 38% 28% 22% 8% -35% -45% -66%

Table 8: Correlation between global bond market and GBP EUR KRW AUD CNY SGD CHF USD JPY index-weighted exchange rate -33% -31% -18% -3% 2% 3% 4% 5% 25%

Table 9: Correlation between manufacturing PMI and AUD KRW EUR GBP SGD CHF USD CNY JPY trade-weighted exchange rates 66% 60% 29% 22% 2% -15% -43% -44% -54%

Source: Refintiv, LGT Capital Partners 28

References LaBarge, Karin P. et al (2014). To hedge or not to hedge? Black, F. (1989). Universal Hedging: Optimizing Currency Risk Evaluating currency exposure in global equity portfolios, and Reward in International Equity Portfolios. Financial Analysts Vanguard Research. Retrieved from: https://personal.vanguard. Journal, 45(4), 16 – 22. Retrieved from http://www.jstor.org/ com/pdf/ISGCMC.pdf stable/4479236 Perold, A., & Evan C. Schulman. (1988). The Free Lunch in CAMPBELL, J., MEDEIROS, K., & VICEIRA, L. (2010). Global Currency Hedging: Implications for Investment Policy and Currency Hedging. The Journal of Finance, 65(1), 87 – 121. Performance Standards. Financial Analysts Journal, 44(3), Retrieved from http://www.jstor.org/stable/25656286 45 – 50. Retrieved from http://www.jstor.org/stable/4479112

Dornbusch, R. (1976). Expectations and Exchange Rate Schmittmann, J. (2010), Currency Hedging for International Dynamics. Journal of Political Economy, 84(6): 1161–1176. Portfolios. IMF Working Papers, Vol., pp. 1 – 44, 2010. doi:10.1086/260506 Retrieved from https://ssrn.com/abstract=1641006

Eun, C., & Resnick, B. (1988). Exchange Rate Uncertainty, Taylor, Alan M. and Mark P. Taylor (2004). The Purchasing Power Forward Contracts, and International Portfolio Selection. The Parity Debate. Journal of Economic Perspectives, v18(4,Fall), Journal of Finance, 43(1), 197 – 215. doi:10.2307/2328331 135 – 158. Retrieved from http://ideas.repec.org/a/aea/jecper/ v18y2004i4p135 – 158.html Froot, Kenneth A., (1993), Currency Hedging Over Long Horizons, NBER Working Paper, Turnill, R. et al. (2017). Getting a grip on FX: No. 4355. Retrieved from http://www.nber.org/papers/w4355 Insights on currency hedging and risk, Blackrock Investment Institute. Retrieved from: https://www.blackrock.com/corporate/ Habib, Maurizio M. and Stracca, L.(2011). Getting Beyond literature/whitepaper/bii-getting-a-grip-on-fx-us.pdf Carry Trade: What Makes a Safe Haven Currency?, ECB Working Paper No. 1288, Retrieved from https://ssrn.com/ abstract=1737628 29 Pina Messina, unsplash.com 30

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