Currencies As A Hedge

In the aftermath of the global credit crisis, it has been hard to find truly uncorrelated asset classes in the capital markets.  Uncorrelated investments are a way to protect against downside risk.  However, since many asset classes continue to move in the same direction simultaneously, it has become increasingly difficult to find those assets that exhibit such uncorrelated behavior.  The hard currency asset class may fill this void. The currency asset class has historically displayed low correlations to traditional asset classes, such as stocks, bonds, and commodities, and offers potential profit opportunities given its unique market structure.  Therefore, the addition of a currency compo­nent to a portfolio may deeply enhance the risk/return profile over time.

During the run-up to the credit crisis in 2008, asset classes became increasingly correlated, and that phenomenon has continued to this day.  Most asset classes generally moved up in tandem approaching the credit crisis; most asset classes moved down together as the credit crisis unfolded; and, broadly speaking, most asset classes have contin­ued to move in lock-step ever since. In order to truly diversify and hedge downside risk, it is important to add uncorrelated assets to a portfolio whenever possible.  It is within this framework of portfolio construction that the addition of the currency asset class may provide excellent potential.  Currency investments have historically exhibited very low correlation to many other asset classes.

The effect of many non-profit seeking participants in the currency market may enhance the uncorrelated attribute of the asset class.  For example, multi-national corporations might contract to buy or sell certain currencies for the primary reason of hedging against currency risk on future earnings or expenses in a certain country; governments and central banks are active in managing foreign currency reserves; even tourists are active currency market partici­pants – when tourists spend money on souvenirs, food or any travel related expense in a foreign currency they influence the price of that currency, even if they are unaware of it.  Such non-profit seekers can have substantial influence on currency price movements and valuations. The effect of these entities’ actions can cause currency prices to move in directions that are largely uncorrelated with most other asset classes.

Additionally, many currency investment strategies are aimed at profiting from trends that are completely unrelat­ed to other asset classes, and therefore also generate return series that are uncorrelated to other asset class returns.  An often overlooked attribute of the currency asset class is that when an investor purchases one currency, the investor is also, by implication, selling another currency, as currencies always trade in pairs. Therefore, the return generated from a currency pair is likely to differ from, and be uncorrelated to, returns of the broad stock market; which is turn adds an effective hedge to a portfolio.