Risk Management: Foundations for a Changing Financial World

CHAPTER 39

CURRENCY RISK MANAGEMENT IN EMERGING MARKETS^am

H. Gifford Fong

One of the major risks investors in emerging markets take is currency risk, and these markets often have few instruments for creating common hedges. The appropriate alternative for managing currency risk in such environments depends on the correlation of the emerging market’s currency with the currency of one of the developed economies. For low-correlation countries, the strategies are complicated and less precise than for high-correlation countries, but they can be effective.

Emerging market investments have the potential for high returns, but the associated risk, including currency risk, can be significant. Many of the standard tools used to hedge currency risk, such as futures, options, and swap contracts, are either not available in emerging countries or, where available, trade in inefficient and illiquid markets, making it very hard to exit from a position.

This presentation provides currency-risk management strategies that can be applied to emerging market investing. Emerging markets are classified into two groups: countries whose currencies are highly correlated with a major currency on which contracts are traded and countries whose currencies have low correlations with major currencies. For the former group, the highly correlated major currency can be regarded as a substitute for the local currency, and traditional instruments can be used to manage currency risk. For the latter group, other strategies, ...