A Hard Lesson from Brexit: Managing Currency Risk
The dramatic, Brexit-induced depreciation of the British pound, combined with the resulting volatility in both global currencies and financial markets, are shocking reminders of how crucial it is to successfully manage currency risk. If not done well, investment managers endanger not only their clients’ wealth, but also their own.
For example, US expatriates working in London without any hedge saw the value of their British pound holdings fall by 8.1% in US dollar values the first day after the Brexit vote, with a further decrease of 3.3% the following day, due solely to currency fluctuations. Japanese nationals in the same situation lost even more: 11.4% in Japanese yen the first day and another 3.5% the next.
If this wasn’t damaging enough, plunging British asset prices and the likely deterioration of expat job prospects in the United Kingdom, coupled with the attendant impairment to human capital, further contribute to an unsettling and pessimistic environment.
All investors with British pound assets as well as global liabilities and financial objectives are faring poorly in the aftermath of the Brexit vote. The reserve currency status of the pound sterling does not mitigate their woes.
Was the Brexit-induced depreciation an exceptional event? Although largely unprecedented, such extreme currency moves are likely to grow more common. Just as climate change leads to an increase in the frequency of severe weather conditions, so heightened geopolitical and macroeconomic stresses make it more likely that currency markets will be subject to violent shifts — much more so than in the recent past.
If there is a consensus emerging from Brexit, it is that uncertainty has increased. This makes any hedging more laborious and costly. In such a context, the only “cheap” way to protect against currency risk is diversification, as Hélie d’Hautefort and I detail in “Overcoming the Notion of a Single Reference Currency: A Currency Basket Approach,” a CFA Institute Research Foundation brief.
People with wealth, whether in human capital or in real or financial assets, almost always have a broad international footprint. The expats mentioned above likely have financial liabilities and objectives not only denominated in British pounds, but also in the currency of their home countries and possibly that of other nations as well. Prudent risk management requires the protection of their global purchasing power. This is why the concept of a single reference currency that underpins traditional wealth management is no longer sufficient.
The single reference currency must be replaced with a suitable currency basket. Doing so will help preserve the necessary purchasing power of global investors while incurring few additional costs beyond those of leaving the inadequate framework of the reference currency.
The effort and expense required to protect a portfolio from currency risk are not especially steep in most circumstances, so global investors should take appropriate action.
Doing nothing and relying on maxims — that currency moves wash out in the medium term, for example — is bad for the financial health of clients and advisers alike.
For more information, read the full CFA Institute Research Foundation brief by Giuseppe Ballocchi, CFA, and Hélie d’Hautefort. And for more Research Foundation briefs, be sure to check out our archives.
If you liked this post, don’t forget to subscribe to the Enterprising Investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©iStockphoto.com/COSPV