Tailored FX solutions can provide stand-alone enhanced income streams or form part of a wider investment strategy. Let's explore the choices
As investors increasingly look to offshore opportunities, foreign exchange (FX) is gaining importance to manage risk and deliver enhanced returns
Managing foreign currency is becoming mainstream for modern investment portfolios. Whether it’s for offshore assets or generating returns from currency trades, it requires an efficient FX strategy to achieve desired goals.
FX hedging portfolios
The most common decision for investors is whether to hedge currency movements for international investments in their portfolio. It requires understanding the relative movements of exposed currency against the underlying asset.
The Australian dollar for example, tends to move in line with global commodity prices, but pricing of commodities is in USD. If I was buying commodities from Australia and the price of my commodities rose, my profit could be eroded if the USD moved in the opposite direction and depreciated. To manage that risk, I could hedge my USD exposure so that currency does not negatively or positively impact my commodities investment.
However, the case for hedging against the US dollar isn’t always strong, and investors need to take a tactical approach. The US dollar is considered a safe-haven currency which tends to appreciate during times of instability, so Australian investors with unhedged exposures have a built-in buffer during turbulent times. During the Global Financial Crisis (GFC), for the 15 month period from January 2008 to March 2009, the S&P500 index lost about 33%, whereas the USD appreciated 21% against AUD, according to Bloomberg date. During this period, unhedged Australian investors would have benefited from USD appreciation and outperformed their peers who hedged by a handsome margin.
Investing in and holding foreign currency
Holding foreign currency can also add value to a portfolio regardless of whether investors hold international assets. Holding a foreign currency gives investors country specific risk exposure which is often uncorrelated to domestic assets, thereby increasing portfolio diversity and decreasing overall portfolio volatility. Japanese yen for example, also considered a safe-haven currency, exhibits a negative correlation to the S&P 500 Index. Investing in Emerging Market currencies could also have diversification benefits because emerging markets can be on different economic cycles, or monetary policy cycles to that of developed economies.
One common strategy an investor can use to take advantage of different monetary policy across countries is called a carry trade. A carry trade is where an investor borrows currencies which are paying lower interest rates and sells them to buy currencies which are paying higher interest rates. Interest differentials can make these trades very profitable. Carry trades were very popular before the GFC when interest rates were generally higher, and gradually lost attractiveness post 2014 when many countries entered an ultra-low interest rate era. The end of historically low interstate rates has attracted attention back to the carry trade.
FX derivatives and tailored FX solutions
For investors seeking overseas exposures, managing the FX component can be important. There are advanced strategies like FX derivatives where a futures contract serves the purpose of locking in an FX rate, even when the transaction happens on a future date. Other instruments like call and put options enable investors to buy and sell if a desired exchange rate is reached.
There are choices available for all investors seeking enhanced returns by taking advantage of FX market volatility. Investing in FX requires an investor to have the necessary knowledge to take a view on the direction of currencies, so research is important. Your investment specialist is an expert in FX markets and can help you access research and provide a sounding board to refine your strategies.
The information contained in this article is gathered from multiple sources believed to be reliable as of the end of September 2023 and is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. Before acting on this information, we recommend that you consider whether it is appropriate for your circumstances and that you seek independent legal, financial and taxation advice before acting on any of this information. ©2023 NAB Private Wealth is a division of National Australia Bank Limited ABN 12 004 044 937 AFSL and Australian Credit Licence 230686.
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