Hedging FX risk

Gold Investor, February 2019

12 February, 2019

Hedging FX risk

Gold is priced in US dollars but investors in the asset class are spread across the world. Francisco Blanch, Head of Commodities and Derivatives Research at BofA Merrill Lynch Global Research, considers whether non-US dollar investors should hedge their currency risk when purchasing gold and other dollar-based commodities.

Francisco Blanch
Head of Commodities and Derivatives Research
BofA Merrill Lynch Global Research

Should investors FX hedge their portfolios? The value of most financial assets, such as equities or bonds, is naturally most stable in their home currency, effectively the currency in which they pay fixed coupons (bonds) or derive their dividends (equities). So when the value of USD home-currency assets is converted into a foreign currency, the returns volatility increases due to the added FX volatility. For this reason, non-USD-based bond investors typically hedge a big portion of their FX risk (e.g. the implied long USD position that arises when a US Treasury bond is eventually sold can be hedged by adding long local FX vs. short USD to the portfolio).

Often, the FX hedge ratio that foreign investors apply to US bonds is more than 50%. Looked at from a different angle, US investors buying foreign bonds or equities whose home currency is not USD often hedge at least part of their implied long foreign FX exposure by adding long USD (vs. short foreign FX) to the portfolio, thereby reducing the overall dollar volatility of the portfolio. Similarly, equity investors, regardless of where they are based, tend to engage in some form of FX hedging to reduce the volatility of returns in their home currency.

Having established the portfolio benefits of FX hedging financial assets, a second question is how much exposure should be hedged. Cross-asset correlations between different financial assets are crucial to this important discussion. Broadly speaking, the more negative the correlation between a particular USD-denominated financial asset and the dollar itself, the less need to implement an FX hedge. According to the cross-correlation relationship between commodities and FX, commodities can serve partly as a natural hedge to currency fluctuations. However, there is little evidence of significant cross-correlations in other time lags, which suggests that this dynamic commodity-FX relationship is very short-lived.

The market value of a commodity depends on its value in use and cost of production, which means its value is most stable in a mix of all the producer and consumer currencies.

Hedging commodities

After all, commodities in broad terms do not have a natural home currency. True, many commodities are priced in USD but that is just a unit of account. The value of a commodity is not necessarily more stable in USD than in other currencies because commodities do not pay dividends or coupons. The market value of a commodity depends on its value in use and cost of production, which means its value is most stable in a mix of all the producer and consumer currencies. In other words, commodities are most stable in a very broad basket of FX whose composition varies depending on the commodity in question. For this reason, the USD is typically strongly negatively correlated with commodity prices in USD, more so than other dollar asset classes. This implies that foreign-based investors may not want to be fully FX hedged as they get somewhat of a natural hedge from the negative USD (vs. local FX) and commodity correlation.

Chart 1: Even for gold the return volatility isn’t significantly lower in any major local currency than in USD

Chart 1: Even for gold the return volatility isn’t significantly lower in any major local currency than in USD

Volatility of gold returns in different currencies (daily returns, since 1991)

Sources: Bloomberg, BofA Merrill Lynch Global Research estimates; Disclaimer

As of November 2018. For methodology details see 'When to FX hedge commodities', March 2017.

 

For emerging market (EM) investors, local currency commodity returns, if unhedged, are generally much more volatile than if fully FX hedged (fully FX hedged return variance is about the same as the USD return variance). For developed market (DM) foreign investors, the volatility of fully FX hedged Bloomberg Commodity Index (BCOM) is not much lower than that of unhedged BCOM. Even for gold, which has one of the lowest variances among single commodities, the return volatility isn’t significantly lower in any major local currency than in USD.

But carrying a fully hedged or completely unhedged portfolio are not the only options. There is a continuum of hedge ratios in-between that may lower the overall volatility of local currency commodity returns. We believe a certain degree of FX hedging, based on the correlation of each commodity portfolio to the home currency of the investor, could be beneficial to non-USD-based investors in DMs and EMs alike. Having established the potential benefits of FX hedging in commodity portfolios, we go on to analyse the spectrum of possible hedging ratios.

Optimal ratios

As a starting point, our works suggests that the optimal hedge ratio for a foreign commodity investor has to be based on a thorough study of the joint distributions between commodity prices and FX. In broad terms, the more volatile an investor’s home currency is, the more benefit (in terms of reducing volatility) a commodity portfolio is likely to derive from an FX hedge. Thus, our work suggests the optimal commodity hedge ratio for DM currencies is between 0.1 and 0.5.

Our analysis makes a strong case for non-USD-based commodity investors to hedge some of their FX risk. Even then, we admit that the volatility-reducing benefit of an FX hedged compared to an unhedged position is relatively small for DM currency investors.

While investors benchmarked against a G10 currency could benefit from commodity FX hedge ratios of 0.1 to 0.5, the optimal hedging ratio for EM FX benchmarked investors is much larger, generally between 0.5 and 1.0 and often close to 1. This is because the return volatility in a given EM currency is very high to begin with and can be drastically reduced by FX hedging.

Put differently, optimal hedge ratios for EM-benchmarked investors, based on the joint historical distributions between commodities and EM FX, are very high. The optimal hedge ratio, where the volatility is minimised isn’t, therefore, very different from a fully hedged position in most cases. In contrast, the hedge ratios for less volatile G10-based investors are lower and the optimal hedge tends to be significantly lower than simply being fully hedged, as the hedge ratio vs. volatility curves are rather flat.

Chart 2: For gold, the volatility reducing benefit of an FX hedged compared to an unhedged position is relatively small for DM currency investors

Chart 2: For gold, the volatility reducing benefit of an FX hedged compared to an unhedged position is relatively small for DM currency investors

Volatility of gold return in local FX, as a function of the FX hedge ratio

Sources: Bloomberg, BofA Merrill Lynch Global Research estimates; Disclaimer

As of November 2018. The historical commodity return variance, FX return variance and their covariances are calculated using monthly data since 1991.
Note the euro curve has a higher volatility than the rest for the fully hedged portfolio due to using a shorter sample period (since 2001). For methodology
details see 'When to FX hedge commodities', March 2017.

 

Our work also shows that a higher level of commodity volatility does not necessarily change the optimal hedge ratio, if the higher commodity volatility comes in isolation and does not change the covariance with the FX.The fact that the optimal hedging ratio does not depend on the volatility of a specific commodity provides some degree of stability in the optimal hedge ratio over time. This occurs even though the variance of the commodity changes over the course of its own inventory cycle. Moreover, increasing the variance of the commodity – all else being equal – doesn’t change the optimal hedge ratio.

Chart 3: The FX hedged portfolio volatility curves as a function of the hedge ratio are especially steep for EMs due to higher FX volatility 

Chart 3: The FX hedged portfolio volatility curves as a function of the hedge ratio are especially steep for EMs due to higher FX volatility

Volatility of gold return in local FX, as a function of the FX hedge ratio

Sources: Bloomberg, BofA Merrill Lynch Global Research estimates; Disclaimer

As of November 2018. The historical commodity return variance, FX return variance and their covariances are calculated using monthly data since 1991.
For methodology details see 'When to FX hedge commodities', March 2017.

 

There are plenty of benefits of FX hedging gold or commodity portfolios, particularly if you are an EM investor.

 

Chart 4: It is not surprising that low-volatility commodities like gold or BCOM index tend to have the highest optimal hedging ratios in most currencies

Chart 4: It is not surprising that low-volatility commodities like gold or BCOM index tend to have the highest optimal hedging ratios in most currencies

Optimal FX hedge ratios (for minimising commodity variance in local currency)

Sources: Bloomberg, BofA Merrill Lynch Global Research estimates; Disclaimer

As of November 2018. For methodology details see 'When to FX hedge commodities', March 2017.

 

That said, when a USD asset is very stable in value (e.g. short-term US Treasury bonds), it typically also has a low covariance with FX rates. Imagine the extreme case of a constant USD bond value – a constant has zero covariance with any random variable including all FX pairs. As lower commodity variance and less negative covariance with FX tend to go hand in hand, the optimal hedge ratio for commodities that have low variance (in USD terms) tends to be higher. So it is not surprising that low-volatility commodities like gold or the BCOM, which has lower volatility than single commodities due to diversification, tend to have the highest optimal hedging ratios in most currencies. In plain English, there are plenty of benefits of FX hedging gold or commodity portfolios, particularly if you are an EM investor.

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