from Silk Invest..
May 10, 2013, By Baldwin Berges
One of the Frequently Asked Questions we get from investors is:
‘How do you hedge the risk of frontier market currencies?”
It is only natural that this topic always comes up because to most investors the frontier market countries are unknown territory. The fact that they have their own currency makes them even more exotic.
We thought you may find it useful if we shared a bit of perspective on the frontier market currencies.
First of all, we don’t believe it makes much sense to hedge frontier currencies. There are a few reasons for this:
The cost of hedging would eat up much of the upside potential. These markets aren’t as efficient nor are they quite as liquid as the more developed markets, this makes hedging expensive. In some cases, there simply isn’t enough of an infrastructure in place to do so.
We also believe there is a better way to deal with frontier market currency risk:Diversification.
Have a look at the chart below, this is a simulation over 10 years. What it shows is that, even by equally weighing the exchange rates of 6 frontier market currencies against the US$. The overall impact is only slightly negative. However, add an average yield to maturity of 10% to the basket and the individual currency risk will be overly compensated for. This is not unrealistic because these are the kinds of yields that can be found in today’s local currency frontier markets.
Each currency is driven by its own fundamentals and has its own supply/demand cycles. Predicting the trajectory of currencies is not easy but we do believe that it makes sense to apply a Purchasing Power Parity (PPP)* method to determine medium and long term value of a monetary unit. Even though making currency calls is not really a part of our investment methodology, this relative valuation does help us when it comes to making asset allocation decisions.
Each currency is a world of its own. Listen to the short podcast below with Tammy Tang, who is attending the Investment Management Program at the London Business School. She has been doing some work with us by taking a closer look at what drives frontier market currencies. In this episode we cover some of the fundamental factors that affect the Kenyan Shilling, The Moroccan Dirham and the Nigerian Naira.