An excerpt from

FALL 2014

THE NEW RULES FOR

WHEN TO HEDGE A CURRENCY Collin Crownover, Global Head of Currency Management

How much higher can the US dollar go? The euro fall? The answer may surprise you, according to new research from our currency team that upends the classic valuation formula­—and gives global investors a higher-precision tool for protecting their portfolios in today’s fluid FX market.

Figure 1: Currency Hedge Ratios Reach Record Highs Across Developed Markets 0.8

0.6

0.4

0.2

0.0

AUD

CAD

n High since 1998

CHF

EUR

GBP

JPY

NOK

SEK

SGD

USD

n 3m high

Source: State Street Global Markets as of September 2014. Past performance is not a guarantee of future results.

For much of the past few years, hedging certain currencies has become the financial version of an uncontested layup. The tremendous misvaluations evident across many currencies were obvious signals of when and in what direction to hedge, making cost/benefit hedging decisions rather simple for investors. On top of that, investors have been taking advantage of the low interest

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“Only when the tide goes out do you discover who’s been swimming naked.” —Warren Buffet

WHEN TO HEDGE A CURRENCY

Why The Sudden Rise In Hedging?

Figure 2: US Dollar Index (DXY) March 31, 2011—October 20, 2014 90 +18% 86

One reason is that hedging costs have diminished. The cost to hedge is based on the interest rate differential between currencies. However, since developed markets currently have accommodative monetary policies with low to zero interest rates, the interest rate differential is generally near zero and the cost to hedge is greatly reduced.

82

78

74

70

Mar 2011

n High since 1998

Jan 2012

Nov 2012

Sep 2013

Sep 2014

n 3m high

Source: Bloomberg as of October 20, 2014. Past performance is not a guarantee of future results. The index returns are unmanaged and do not reflect the deduction of any fees or expenses. The index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income.

rates in today’s developed markets, which, because of the way hedging costs are calculated, have substantially reduced the expense associated with currency hedging. However, as strongly overvalued and undervalued currencies start to mean revert, the neon signs for when and how to hedge are beginning to fade. Determining when to hedge a currency has never been a purely scientific affair, and as currency misvaluations become less conspicuous, some investors may elect to simply neglect hedging programs altogether. But we think investors are better served to continue hedging using dynamic tools to manage currency risk. At SSgA’s currency management team, we recently asked ourselves, is there a better way to model currency that might give investors more precise tools for deciding when and how to hedge? We have re-engineered our own models and back-tested the results,

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Out of 10 developed market currencies, five have seen hedge ratios hit an all-time high in the last three months (Figure 1).1

with surprising ramifications for some of the most pressing questions in currency markets today. As investors now ask, for example, if the United States dollar still has legs, or if there is more room to fall in the euro, we find that the standard “fair value” currency valuation model is not giving us the full story and is, in many cases, actually giving us the wrong story. We explain here why dynamically hedging currency is so important, and how our new model is better equipped to defend against currency losses.

Currency volatility rose 51 percent from July through September 2014.

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Additionally, currency volatility has increased, with the Deutsche Bank Currency Volatility Index rising 51 percent, from 4.93 percent on July 21 to 7.43 percent on September 30. The dramatic appreciation in the US dollar is driving much of the volatility (Figure 2). For US-based investors in foreign assets, appreciation of the US dollar, of course, means a greater risk that they will pocket less money after converting from foreign currency back to dollars, driving increased hedging of foreign currency. Some of the hedging fever may also stem from concerns about monetary policies that intentionally devalue currencies. As policymakers in underperforming, deflationary economies resort to the jolt that a currency devaluation can provide (i.e., increasing demand for exports and propping up inflation), investors seek to hedge more to prevent losses. But this heightened consciousness for currency risk, and concomitant hedging, may not last. Hedging is an essential process—although not necessarily a core competence—for investors wishing to reduce currency losses that could undermine foreign-denominated equity or fixed-income performance. Calculating when the potential

WHEN TO HEDGE A CURRENCY

Figure 3: Declines in Eurozone Productivity Display Correlation with EUR Depreciation

Even as first-year economics students, we knew that exchange rates depend on more than inflation.

Relative Productivity

EUR /USD 1.6

-0.2

1.5

-0.6

1.4 -1.0

of those losses outweighs the cost of applying the hedge is inherently difficult and somewhat ambiguous work. To get around that, standard hedging is often done rather formulaically using the rule of thumb that hedging 50 percent of foreign currency exposure generally provides a reasonable cost-benefit trade-off for most international portfolios (although some countries, such as the US, tend to hedge less). The more dynamic hedging that we’re seeing a spike in now—where investors take long-run, tactical views on currency and tilt around their strategic hedges accordingly—requires a sharper eye for currency movement, and as such is often only done if calls on a currency are relatively straightforward. This is why, for example, hedging against foreign currency depreciation vis-à-vis a rising dollar is playing out so strongly; the rise in the US dollar was widely anticipated, given the relative strength of US growth, the decline in the US deficit and the reduction in accommodative US monetary policy. However, well-telegraphed, highly visible currency trends are now shifting, begging the question of whether investors will continue to actively hedge currency exposure once appropriate positioning isn’t so obvious. Investors have seen several currencies get back closer to what appears to be a natural set point. This includes the significant fall

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1.3 -1.4 1.2

-1.8

Jan 2008

— Relative Productivity

2009

2010

2011

2012

2013

Sep 2014

1.1

— EUR/USD

Source: EIU, WM Company as of September 30, 2014. Past performance is not a guarantee of future results. The correlation coefficient measures the strength and direction of a linear relationship between two variables. It measures the degree to which the deviations of one variable from its mean are related to those of a different variable from its respective mean.

in the Australian dollar in 2013, following soaring altitudes against the US dollar in 2011 and 2012; the euro, which has fallen off a cliff to such an extent that investors are questioning if it can fall any further; and the appreciation of the US dollar, with some questioning how much steam is left in its upward trajectory. If currency misvaluations are less palpable, investors may shun dynamic hedging and potentially misread their hedging needs due to a perceived lack of opportunity and a too hands-off approach. But while we think dynamic hedging is the best approach for investors, having the right tools to implement it is key. Indeed, when we took a step back and looked at existing models that

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investors typically use to value currency, we realized that a new, finely tuned currency valuation model provides more accurate— and surprisingly different—recommendations for hedge positioning.

In backtesting, the new model improved annual hedging returns from January 2000 to present by over 50 bp.

WHEN TO HEDGE A CURRENCY

Figure 4: Simulated New Model Additional Annualized Hedging Returns Under- or Spot, Valuation— Valuation— Overvalued?— Currency Pairs October 1, 2014* Old Model New Model New Model

Additional Hedging Returns vs. Old Model 2000–2014 (bps/yr)

Additional Hedging Returns vs. Simple 50% Foreign Assets Hedged 2000–2014 (bps/yr)

AUD/USD

0.87 0.72

0.78 Overvalued

69

EUR /USD

1.26

1.31

1.21 Overvalued

-19**

136

GBP/USD

1.62

1.69

1.59 Overvalued

50

180

USD/JPY 109.58 77.68

89.57 Overvalued

124

217

67

10

USD/CNY

6.14

8.79

7.02 Undervalued

201

Source: State Street Global Advisors, Bloomberg as of October 1, 2014. *Past performance is not a guarantee of future results. **The underperformance here primarily came in 2012-13, when the Fed’s balance sheet was expanding and the ECB’s was shrinking, temporarily putting upward pressure on EUR/USD. Indeed, the new model has handily outperformed in 2014. The simulated performance shown is not necessarily indicative of future performance, which could differ substantially. Please see the disclosure section for additional simulation information. The information contained above is for illustrative purposes only.

The Old Rules for When to Hedge The existing, conventional way to value currency uses purchasing power parity (PPP), the theory being that the exchange rate between two currencies must reflect the same purchasing power. This methodology is exemplified by the “Big Mac Index.” Under the theory of PPP, if either two units of Currency A or one unit of Currency B can purchase a Big Mac, then the exchange rate should be—or is fairly valued at—2 to 1. This method has worked fairly well in the past to estimate fair values of currency and to hedge against some of the larger swings in currency. However, we have always known that the PPP method is not telling the whole story. The PPP method, based on values of goods, relies on price inflation as the sole long-term driver of the exchange rate. Even as first-year economics students, we learned that exchange rates depend on much more than inflation, but we did not have consistent evidence of this until recent history provided certain test cases. First, starting in 2008, falling relative productivity in the eurozone created a perfect environment to look at how productivity and

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currency intertwine (Figure 3). Second, the commodity super cycle, with skyrocketing price growth in commodities from the late 1990s through recent years, offered up a study in how certain currencies—such as the Australian dollar—would respond once the tide shifted and commodity-related growth slowed in Asia. These periods of heightened currency shocks allowed us to weed out evidence of other factors that drive currency, and to home in on flaws in the PPP model. As Warren Buffett put it, “Only when the tide goes out do you discover who’s been swimming naked.” Research shows that there are other factors—namely productivity growth and terms of trade—that significantly impact a currency and should be used to augment estimates of fair value.

The New Rules Studies show that productivity growth is a major determinant of a currency’s fair value and should augment the traditional PPP method of valuing currency. Countries with more productivity draw in more foreign investment, which pushes up the value of local currency. Additionally, increased productivity puts upward pressure on wages, and as local citizens become wealthier, they bid up the value of services (i.e., nontradable goods where higher

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pricing cannot be arbitraged back down). This also drives the local currency higher than PPP would suggest. The other silent harbinger of currency valuation surfaced by the research is terms of trade—or the ratio of a country’s export prices to its import prices. Terms of trade is a way to view whether a country benefits (positive terms of trade) or loses (negative terms of trade) from trading. For example, if a country receives less money for exports (lower prices at home) while having to pay more for imports (higher prices abroad); this is a negative terms of trade shock. However, if terms of trade increases—i.e., a country starts to receive more for exports relative to what it is paying for imports—the wealth of the local citizenry rises. Similar to productivity, this prompts greater spending on services (nontradables) and therefore real (adjusted for inflation) exchange-rate appreciation. Higher terms of trade also enlarges a country’s national wealth, which can stimulate capex and foreign investment, further appreciating the local currency. But, as noted, the existing PPP model completely ignores these trends, placing all its emphasis on inflation as the determinant of a currency’s fair value. In the mechanics to include productivity and terms of trade in

WHEN TO HEDGE A CURRENCY

Figure 5: MSCI Market Cap-Weighted Index of USD Returns and USD Fair Values 145

130

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fair value calculations, we built a regression model that includes both of these variables to explain the movement in equilibrium real exchange rates over the long term. Our research indicates that relative productivity (relPROD) is half as important as relative inflation, and relative terms of trade (relToT) is half as important as relative productivity.2 The formula is such:

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Jan 1990

— USD Index Spot

1996

— USD Index PPP

2002

2008

Jul 2014

— USD Index Enhanced PPP

The resulting fair value is then used in calculations to determine the misvaluation of currency in the market. The optimal hedge ratio for each currency pair is determined by mean-variance optimization of a sample of deviations from fair value to market value to generate the best expected risk-adjusted returns from a currency hedging strategy.3

Source: MSCI, State Street Global Advisors, WM Company as of July 31, 2014. Past performance is not a guarantee of future results. The index returns are unmanaged and do not reflect the deduction of any fees or expenses. The index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income.

Figure 6: Productivity as a Structural Driver of Exchange Rates CNY /USD Real Exchange Rate (log)

CNY/USD Relative Productivity (log)

0.0

0.6

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1995

— CNY/USD Real Exchange Rate (log)

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2005

2009

— CNY / USD Relative Productivity (log)

Source: FactSet, DataStream as of June 30, 2014. Past performance is not a guarantee of future results.

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Jun 2014

0

Under the new model, the dollar is almost 10% higher than what’s calculated by the old, and the euro probably has even farther to fall.

The Results When productivity and terms of trade are included in estimates of fair value, it is evident that PPP regularly misses the mark in its pricing of currencies. When testing historical data for hypothetical portfolios, including 10 developed market and 22 emerging market currencies, hedging ratios under the new model improve the information ratio for the majority of the portfolios in the sample. According to SSgA

WHEN TO HEDGE A CURRENCY

Figure 7: Terms of Trade as a Structural Driver of Exchange Rates AUD/USD Real Exchange Rate (log)

AUD/USD Relative Terms of Trade (log)

0.30

0.35

0.00

0.00

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-0.60

-0.90

-0.70

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2003

n AUD/USD Real Exchange Rate (log)

2007

2010

Jun 2014

-1.01

n AUD/USD Relative Terms of Trade (log)

Source: FactSet, DataStream as of June 30, 2014. Past performance is not a guarantee of future results.

research, this boosts the combined sample’s annual hedging returns from January 2000 to present by over 50 bps and improves the information ratio by about 0.3, compared to the PPP model. One striking example of the gravity of productivity growth on currency valuation is in the US. Despite steady US dollar appreciation already since mid-2011, relatively high US productivity suggests that the US dollar should be even stronger than conventional PPP valuation suggests. This means that US investors may have even more of a reason to hedge against US dollar appreciation than PPP may imply. Under the new model, the market value of the US dollar is almost 10 percent higher than what’s calculated by PPP. Figure 5 shows the path of the US dollar, alongside fair value estimates from the standard PPP method and from the enhanced methodology that accounts for productivity and terms of trade. Note that

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the new enhanced fair value estimate is consistently higher from roughly the early 1990s onward. Given that the US Federal Reserve (the Fed) has pumped money into the system via quantitative easing since the financial crisis, it’s not surprising that the US dollar has taken some time before rallying. However, now that the Fed has taken its foot off the stimulus gas pedal, we are starting to see the true US economic fundamentals reflected in the dollar. The improving economic environment in the US—and the better productivity in the US versus abroad—says that the dollar should continue to appreciate more than is currently positioned for by many investors. In other examples, the estimate of fair value for the Chinese yuan jumps about 20 percent if you include productivity, as average productivity growth in China outpaces emerging Asia as well as developed nations.

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In other examples, fair value jumps about 20 percent for the Chinese yuan and about 10 percent for the Australian dollar. Figure 6 shows the relationship between productivity and real exchange rates in China. The chart displays that the two work in lockstep; as productivity in China has increased relative to the US dollar, the equilibrium real exchange rate (CNY/USD) has generally appreciated as well. By contrast, research shows that the values of the euro and the yen are much weaker once you factor in the anemic productivity growth in those countries. Given long-run productivity declines in the eurozone, the euro—despite how far it’s already fallen— probably has even further to fall than traditional fair value calculations tell us. Figure 7 shows a similar role played by terms of trade in Australia. As Australia’s terms of trade improved relative to the US dollar during the run-up of the commodity super cycle, the real exchange rate for the Australian versus the US dollar appreciated roughly in tandem. But when that tide turned and Asian demand for exports declined, we could pinpoint just how much terms of trade drove that initial appreciation—about 10 percent. Now, even though the super cycle has faded, the traditional PPP model fails to take into account that Australia still exports a lot more than it imports, and its terms of trade are still high. Given this large impact, in our view, terms of trade has to be included as a component of currency valuation for the Australian dollar going forward.

WHEN TO HEDGE A CURRENCY

Implications for Investors PPP, one of the most widely used models to value currency, can be enhanced by placing importance on productivity and terms of trade to judge the relative value of one country’s currency versus another’s. With mean reversion of currencies taking shape, blurring the lines between fair valuation and mispricing, it is all the more crucial to view hedging with a more powerful microscope. Most people aren’t hedging for the fun of it; they own foreign assets and need to make sure that their returns are not stifled by movements in foreign currency. For example, in the last cycle of massive US dollar appreciation (1995–2002), a US investor in, for example, the MSCI All-World Index could have made nearly 50 percent in returns absent the effects of currency repatriation. However, with currency conversion included, that investor would have pocketed less than 10 percent if no steps to hedge that exposure had been taken. In today’s stock market, when equity valuations are high, and starting to come under pressure, it is especially important for foreign asset investors to hedge currency risk most effectively and minimize currency losses on returns as much as possible. Source: State Street Global Markets; data dating back to 1998.

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2

In the regression model included here (and according to PPP), the spot rate divided by the relative consumer price index (CPI, a measure of inflation) computes the equilibrium real exchange rate (RER).

3

 ean-variance optimization, also known as Modern M Portfolio Theory (MPT) is an asset management tool used to optimize the balance between risk (the variance) and return (the mean).

FOR INSITUTIONAL USE ONLY. Not for use with the public. Investing involves risk including the risk of loss of principal. The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information. The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSgA’s express written consent. The views expressed in this material are the views of SSgA Currency Management through the period ended October 31, 2014 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Currency Risk is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged. Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations. Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries. Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates rise bond values and yields usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. Risk associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions. Investing in commodities entail significant risk and is not appropriate for all investors. Commodities investing entail significant risk as commodity prices can be extremely volatile due to wide range of factors. A few such factors include overall market movements, real or perceived inflationary

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trends, commodity index volatility, international, economic and political changes, change in interest and currency exchange rates. All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment. The simulated performance shown was created by SSgA Currency Management. Fair values are computed for 10 Developed Market (DM) and 22 Emerging Market (EM) currencies. The simulation is performed monthly, with rebalances at month-end. The Benchmark Portfolio used is the MSCI Country Index, 50% hedged to US dollars at all times. Transaction costs of 2 bps are used (one-way). Annual Total Factor Productivity growth rate data is sourced from FactSet /EIU. If available, official quarterly terms of trade data is sourced from FactSet or Datastream, else annual EIU terms of trade data is used. The results shown do not represent the results of actual trading using client assets but were achieved by means of the retroactive application of a model that was designed with the benefit of hindsight. The simulated performance was compiled after the end of the period depicted and does not represent the actual investment decisions of the advisor. These results do not reflect the effect of material economic and market factors on decision-making. The simulated performance data is reported on a gross of fees basis, but net of administrative costs. Additional fees, such as the advisory fee, would reduce the return. For example, if an annualized gross return of 10% was achieved over a 5-year period and a management fee of 1% per year was charged and deducted annually, then the resulting return would be reduced from 61% to 54%. The performance includes the reinvestment of dividends and other corporate earnings and is calculated in various currencies. The simulated performance shown is not necessarily indicative of future performance, which could differ substantially. The MSCI is a trademark of MSCI Inc. Source: MSCI. The MSCI data is comprised of a custom index calculated by MSCI for, and as requested by, SSgA. The MSCI data is for internal use only and may not be redistributed or used in connection with creating or offering any securities, financial products or indices. Neither MSCI nor any other third party involved in or related to compiling, computing or creating the MSCI data (the MSCI Parties) makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and the MSCI Parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to such data. Without limiting any of the foregoing, in no event shall any of the MSCI Parties have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages.