Emerging Markets Seem Attractive, But Forex Risks Abound

The era of globalization is upon us. No longer are investors content or restricted to investment offerings in their own country.  In order to serve investors seeking greater returns, markets have opened up across the globe to attract investor capital. 

Nearly all full-service brokers can access foreign exchanges for you and purchase and hold securities in their domestic currencies.  If this process appears too daunting, then a plethora of exchange-traded funds await your review. 

These funds can be broad based, region or country focused, or assembled by choosing only the fastest growing sectors, and these ETFs also offer the convenience of being traded on U.S exchanges.

Forex chart

The reason for these offerings is simple.  Emerging market countries have been growing at two to three times the rate of developed country economies for the past decade.  Offshoring activities, together with low transportation and communication costs, have ignited an economic transformation on a global scale, especially in Asia.  The results for the past five years for a popular emerging market fund speak for themselves in the chart below:

Over the past five years, the S&P 500 Index has remained flat while the emerging market fund share value has grown 60%.  The global recession may have made the path a bit rocky at times, but the end result cannot be denied.  However, investing in emerging market countries is not for the faint of heart.  Risks abound.  Political, economic, cultural, regulatory, reporting transparency, and legal risks are omnipresent, not to mention liquidity issues and wide Bid/Ask spreads.  When all is said and done, currency risk is not easily mitigated either.  Appreciation in stock values may occur, but may also be wiped out by depreciating currency values.

How does a professional in currency trading hedge against foreign exchange risk?  Typically, an expert in these matters would use forex options to hedge against adverse movements in a currency pair value.  A forex option is the right, but not the obligation, to purchase a specific currency with another currency at a specified exchange rate and at a specified time in the future.  The “American” version permits conversion at any time before the expiration date.  A “premium” must be paid for the option, but its value reacts in an opposite manner to the underlying security.  If the value of the security declines due to falling exchange rates, the forex option will appreciate and offset the loss.  If the opposite occurs, then the cost of the premium is lost.  Hedging is similar to buying insurance, but the term and liquidity may dictate a higher than desired premium.

The use of forex options to hedge currency risk is a complex exercise, not recommended for the inexperienced.  While most developed countries allow the trading of currency derivatives on their exchanges, many emerging market countries do not.  It is also true that many brokers do not offer forex options as well.  There have been funds created that have attempted to hedge currency risk with mixed results, but the key determining factor is the near to long-term forecast for the U.S Dollar.  If export growth and forex reserves accumulate, emerging market currencies will most likely appreciate. 

Global economists project that emerging markets will continue to outpace advanced economies in real GDP growth for decades to come.  Experts also suggest that an “asset bubble” has formed in these securities and that many are currently overpriced.  Diversification and an allocation limit of 15% is best practice.  Volatility will surely be present, but emerging market officials have learned from past lessons, and currency issues may be mute if current growth dynamics persist.

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