Indirect or “Dirty” Hedging

After nearly two years of increasing volatility in major currency pairs, many investors are looking at ways to reduce or isolate risk. Last year, literally every foreign currency depreciated against the U.S. dollar.4 As we have written about extensively, U.S. dollar strength may be poised to continue as part of a secular bull market. Not surprisingly, some of the biggest casualties to dollar strength have been in emerging markets. In markets where the dollar is broadly stronger against foreign currencies, investors could use a basket of developed and emerging market currencies as a way to indirectly hedge the value of the U.S. dollar.

Major Currency Market Performance vs. U.S. Dollar

While some emerging market currencies, such as the Russian ruble and Colombian peso, fell by more than the yen and euro in 2014, on average, the Bloomberg Dollar Spot Index rose by 10.95%. While this “dirty” hedging strategy would not have helped much with the Russian ruble, we believe that it would have performed well for hedging the vast majority of other emerging market currencies. As we show in the table, this strategy would have also performed well so far in 2015. At the end of the day, the value of this approach is that investors are able to profit from a strengthening U.S. dollar without the significant costs of hedging all emerging markets directly. In the case of the Bloomberg Dollar Spot Index, the annualized cost of hedging is less than 1%, a significant discount to hedging EM currencies directly.

While currency risk seems to be top of mind for many investors, currency volatility in emerging markets has been a difficult risk to manage. In our view, a broad-based strategy that goes long the U.S. dollar against a basket of foreign currencies could be an attractive alternative to direct hedging of EM currency risk. While this approach will not perfectly offset losses in all market scenarios, we believe that current tradeoffs favor an indirect approach to hedging.

1Source: Bloomberg, as of 4/13/15.
2Represented by the Bloomberg Dollar Spot Index (BBDXY).
3Source: Nier, Erlend and Sedik, Tahsin and Mondino, Tomas, Gross Private Capital Flows to Emerging Markets: Can the Global Financial Cycle Be Tamed? (October 2014). IMF Working Paper, Vol. , pp. 1-34, 2015.
4Sources: Bloomberg, WisdomTree.

Important Risks Related to this Article

Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. Investments in emerging, offshore or frontier markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments. Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations.

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