Gold mitigates foreign-exchange risk when investing in emerging markets

Published 31st January 2013

Categories: Investment

Download (pdf, 33.96 KB)

Investors in emerging market assets can use gold to reduce the risks associated with exchange-rate volatility and benefit from significant cost efficiencies, according to a new report from the World Gold Council. Exchange-rate risk is a serious and increasingly relevant issue as investors in the US and other developed economies look beyond their domestic markets to diversify their portfolios and pursue opportunities for greater returns.

Given the significant changes in the global economic landscape over the past decade, conventional wisdom about exchange-rate hedging has evolved. The robust growth in emerging markets and aggressive monetary policies in developed markets have resulted in expanded interest-rate differentials and, consequently, increased traditional exchange-rate hedging costs. Given the current trade-off between the costs of hedging and its benefits, many investors opt to leave their allocations un-hedged, exposing their portfolios to significant downside risks.

Juan Carlos Artigas, Global Head of Investment Research at the World Gold Council, said:

“Gold’s unique characteristics as an asset and currency hedge are particularly relevant to investors with emerging-markets exposure, where currencies and asset prices are more vulnerable to price swings and tail-risk events. Using a gold overlay can reduce currency-related losses, without increasing the opportunity cost or negating the potential benefits of investing in emerging markets.

“Gold has a positive correlation to emerging market growth, and a negative correlation to the US dollar and other developed-market currencies. Gold has a low investment cost relative to traditional foreign exchange hedges and is a proven hedge against tail-risk. Given these qualities, there is a strong argument for complementing existing exchange-rate hedging strategies with gold.”

The World Gold Council report, Gold and currencies: hedging foreign-exchange risk, explores the advantages and costs associated with hedging foreign-exchange exposure. The analysis demonstrates that portfolios with emerging-market exposure hedged using gold, exhibited improved performance. Hedging with gold resulted in lower costs and levels of risk and higher returns, when compared with portfolios using a purely currency-based hedge, or no exchange-rate hedge at all.

Key findings:

  • Gold offers significant benefits in optimising risk-adjusted returns during periods of extreme market stress and heightened currency tail-risk. Over eight periods of crisis conditions examined in the report, including gold in currency-hedging strategies in an emerging-market portfolio offered cumulative outperformance of 2.4% above an un-hedged portfolio and over 1% above a currency-hedged portfolio.
  • Adding a gold overlay to emerging-market assets reduced portfolio peak-to-trough declines over the past decade, on average, to 9.2% from a 12.5% decline in currency-hedged portfolios, and a 13.1% decline in unhedged portfolios.
  •  The costs of implementing a gold-based hedging strategy are smaller than those associated with most currency hedges for emerging market currencies. The average costs of hedging a basket of emerging-market currencies is currently over 4% compared to less than 50 basis points on borrowing costs for a gold overlay.

While this study focuses on emerging market investment and currency hedging from a US dollar perspective, its findings have wider ranging applications and are broadly compatible with other research on the merits of gold as a foundation to portfolios, from the World Gold Council and independent global advisory firms including New Frontier Advisors and Oxford Economics. There is now a substantial body of statistical evidence indicating that an allocation to gold between 2-10% is optimal across a range of risk profiles, economic environments and currencies.

The Gold and currencies: hedging foreign-exchange risk report can be viewed here and on the World Gold Council app for iPad and iPhone, which can be downloaded from www.itunes.com.

For further information please contact:

James Murray
World Gold Council
T +44 20 7826 4754
E james.murray@gold.org

David Schraeder
World Gold Council
T +1 917 224 6473
E david.schraeder@gold.org