Javier Corominas and Jonathan Scott recently contributed a chapter to a new book by Pojarliev and Levich on 'The Role of Currency in Institutional Portfolios'. The chapter discusses the economic rationale behind emerging market currency returns and the rewarded risk that investors can access by investing in them.
For more on this book, please click here.
The Case for Emerging Market Currency Investment
As emerging market (EM) countries become richer their currencies
become stronger and in so doing their currencies converge with
those of developed countries. One of the most compelling arguments
for this is based on the convergence of EM per capita income
towards that of industrialised (OECD) countries. This is probably
best explained by the work of the economists Balassa and
According to the Balassa-Samuelson (B-S) effect the real
exchange rate (i.e. how many real goods does a particular currency
unit actually buy) is broadly a function of relative productivity
growth over the longer term. Countries that exhibit high
productivity growth are likely to have a tendency to see rising
domestic prices and thus an appreciating real exchange rate.
Assessing Sources of Excess Return in
This summary paper represents Record's view of the opportunities
to generate excess returns in currencies (November 2011). Currency
exposure is often viewed as a source of extra volatility which is
unrewarded in the sense that it generates no excess return over
In this paper we counter this view, arguing that the FX market
resembles other markets in that it contains opportunities which
persistently deliver excess returns. The existence of return
opportunities in the currency market (which is, by its nature, a
zero sum game) is justified by two facts: firstly, a large
proportion of market participants are not profit seekers; and
secondly, countries in external balance of payments deficit have to
make their currencies' prospective return sufficiently good to
attract currency investors.
The Currency Forward Rate Bias as an Asset Class
Currency markets in the aggregate are necessarily
'zero sum' markets - i.e. an appreciation in the value of one
currency can only be expressed by reference to another currency,
which necessarily experiences a corresponding depreciation.
There is therefore no aggregate 'return' from simply holding
currencies, by contrast to equities, for example.
Notwithstanding this aggregate performance, there
are empirically-observable and persistent price patterns that
prevail in currency markets. The purpose of this paper is to
evaluate the proposal that one of these price patterns, the
'forward rate bias' (FRB), represents a rational 'risk premium',
i.e. payment of a reward for risk assumed in connection with an
The significance of the identification of the FRB,
or indeed any other price pattern, as a risk premium is that it
provides justification for long-term strategic investors, who seek
to allocate capital to rewarded risks, to regard that premium as an
asset class, and hence potentially worthy of long-term strategic
capital allocation, provided certain criteria are met. This
paper also considers what those additional criteria might be, and
evaluates whether the FRB meets them.
The Balassa-Samuelson Effect Explained
The most compelling argument for investing in emerging markets
relies on per capita income convergence towards that of
industrialised countries. This, the Balassa-Samuelson effect, is
examined in this paper.