In its new survey, FX Trumps Correlation, Axioma takes a look at how currency effects dominated portfolio risk in the aftermath of the US presidential election as well as other major market events in 2016, such as Brexit and the Fed rate hike.
The study was conducted by Christoph Schon, CFA, CIPM, executive director of applied research at Axioma, which provides investment risk and portfolio management solutions to financial institutions.
Axioma noted that over the last year, global FX markets have experienced significant volatility against the backdrop of multiple geopolitical factors that fueled its rapid movements. The USD, however, saw an upward projection, as financial markets rallied behind the possible positive effects of a Trump economy. Even as President Trump rolled out his controversial social, political and economic plans, the U.S. FX markets remained strong. This might be good news for USD denominated investments, but portfolio managers around the world scrambled to hedge against other currency losses and plan ahead for greater FX volatility that might hit performances as future global geopolitical uncertainty piles on.
Axiomas study explores how the risk decomposition changes when the base currency of a portfolio is altered and a currency-hedge is applied using five scenarios: unhedged USD denominated portfolio, hedged USD portfolio, and unhedged GBP, EUR and JPY portfolios.
What it found was that varying the portfolio currency has a significant impact on risk, in terms of overall volatility and risk decomposition. A few key findings:
In the cases where only a small part of the assets are denominated in the currency of analysis (JPY and GBP), risk appears to be largely dominated by exchange rate fluctuations.
Diversification effects from low or negative cross-asset class correlations play only a minor role in this instance.
The currency-hedged portfolio, on the other hand, shows more familiar patterns, in which equity market volatility is offset by safe-haven assets, such as gold and government bonds. As a result, total portfolio volatility is the lowest value of all five scenarios examined.
