Is Currency an Asset Class?

March 29, 2016 |
3 minute read

Currency risk can best be described as the surprise impact that currency exposure has on an investment portfolio. Although currency risk typically confounds investors, it is easy to measure – it is the difference in the return to an unhedged portfolio position versus that portfolio position hedged back to the investor’s domestic currency. So simple to measure, yet so difficult to figure out.

Currency risk has long bedeviled investors, with many opinions and recommendations as to whether investors should even hedge their currency exposure. Unfortunately, there is no easy answer and the debate over the best currency strategy continues. Some take the view that, over the long term, currency fluctuations will average out. Another school of thought is to actively manage your currency hedging ratio by determining the hedge ratio that minimizes portfolio volatility. Finally, others argue that if there is no risk premium associated with currency exposure, and investors are not therefore compensated for the volatility that it introduces into the investment portfolio, then the currency should be completely hedged.

Taking a step back, currency risk is fascinating because it is a by-product of international investing. Currency has no long-term expected return because, although it is a risk exposure, it is not an economic asset for which a long-term risk premium exists. Investors do not invest in currencies to capture a risk premium; instead, they invest in international assets denominated in a foreign currency. As a result, investors received currency exposure as a side effect of their internationally diversified investment portfolios.

Another way to think about currency is that it has no intrinsic or standalone value by itself. For example, we can assess whether the stock market is over or undervalued by using fundamental economic data embedded in the equity market. Corporate earnings, profit margins, P/E multiples, dividend yields and the like can all be measured and assessed to determine if the stock market is rich or cheap.

Not so with currencies. We cannot say whether the US Dollar is overvalued or undervalued on a standalone basis. We can only make this determination relative to another currency. For example, we can say that the USD is expensive compared to the Euro or cheap compared to the British Pound. Currencies are not an asset class and there is no long-term risk premium to capture. Instead, they are merely a relative trade compared to another currency.

Yet, why do investors believe that currencies are an assets class? The reason is that currency strength or weakness compared to other currencies tends to be episodic. The USD is currently strong relative to the Yen, the Euro, and the Remimbi. This is because each of these countries or economic regions is suffering from significant economic headwinds and they have all devalued their currency to stimulate their export industry. It is expected that the Central Banks of these regions will continue to lower the value of the Yen/Euro/Remimbi relative to the USD to stimulate export growth, and this might go for years. As a result, the USD begins to look like a valuable asset class. Unfortunately, there is no long term risk premium for the USD that would allow us to build any reasonable return expectation—the strength of the USD relative to other currencies is at the whim of central banks.

Which brings us to another topic. There are few certainties in the investment world but here is one: If you hedge your international currency exposure, at some point, you will lose money. I cannot tell you when, but currency fluctuations are large and extreme and will eventually cause your currency hedge to lose money.

Consider the chart below which measures the correlation of the USD/Yen and underlying local stock market. We can observe large, dramatic swings in the currency value relative to the local equity market. For example, the correlation between the USD/Yen exchange rate and the Nikkei stock market ranges from + 0.80 to -0.80. This large dispersion indicates that there were times when it was advantageous to hedge the Yen and times when hedging the Yen resulted in a loss. Predicting currency strength or weakness is not easy. As the chart demonstrates, the relative strength of a currency can turn quickly based on a whole host of competing monetary and fiscal policies across international borders.

ch-currencyYet, some currency traders make money don’t they? Yes, they do. But they don’t seek to capture a long term risk premium the way you would through normal portfolio construction. Instead, they monitor central bank movements and government fiscal policies to jump on or off a currency bandwagon when they see fit. For them, currency is not an investment associated with an asset class: it is a trade.

At Commonfund, we monitor currency movements to determine if there is a tactical advantage to hedging or being “long” a currency. We are mindful that some currencies are simply too volatile to make effective tactical calls. However, we are well aware of the “race to the bottom” with respect to other central banks reducing the value of their currency relative to the USD to enhance exports and we use this knowledge to look for opportunities to enhance our portfolios.

So where does this leave us? Unfortunately, back where we started—there is no easy answer to currency exposure. But, consider this: ask yourself the reason for putting on the currency trade in the first place. If it is for risk reducing purposes, then put aside the behavioral emotion of regret and recognize that at some point you will lose money on your currency hedge. This is OK because you are not trying to earn a risk premium from currency. Instead, just like trying to eject an unwanted relative from your home after the Holidays, you are trying to eject an unwanted risk exposure from your portfolio.

Visit our Commonfund Research Center to learn more about risk management. 

Mark J.P. Anson


Mark J.P. Anson

Chief Executive Officer and Chief Investment Officer, Commonfund

Stay connected with the Insights Blog

Popular Blog Posts

Market Commentary | Insights Blog

Chart of the Month | The Surprising Relationship Between Money Supply and Inflation

The potential for rising inflation is becoming a top concern for many investors and consumers. Many believe that inflation is already here as evidenced by price increases in commodities, homes,...
Perspectives | Insights Blog

The Case for Using the Higher Education Price Index® (HEPI) to Define Inflation for Colleges

When calculating return targets for an endowment portfolio, a conventional piece of the equation is often the Consumer Price Index (CPI). CPI plus 5% is the common short-hand formula for institutions...
Governance And Policy | Insights Blog

Endowment Management and the Three Primary Responsibilities of a Board

The fourth blog in the “Six Ps of Investment Stewardship” series addresses People, specifically how boards function within an organization. To learn more about the first four principles in the series...


Certain information contained herein has been obtained from or is based on third-party sources and, although believed to be reliable, has not been independently verified. Such information is as of the date indicated, if indicated, may not be complete, is subject to change and has not necessarily been updated. No representation or warranty, express or implied, is or will be given by The Common Fund for Nonprofit Organizations, any of its affiliates or any of its or their affiliates, trustees, directors, officers, employees or advisers (collectively referred to herein as “Commonfund”) or any other person as to the accuracy or completeness of the information in any third-party materials. Accordingly, Commonfund shall not be liable for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on any statement in, or omission from, such third-party materials, and any such liability is expressly disclaimed.

All rights to the trademarks, copyrights, logos and other intellectual property listed herein belong to their respective owners and the use of such logos hereof does not imply an affiliation with, or endorsement by, the owners of such trademarks, copyrights, logos and other intellectual property.

To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated herein. Forecasts of experts inevitably differ. Views attributed to third-parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Market and investment views of third-parties presented herein do not necessarily reflect the views of Commonfund, any manager retained by Commonfund to manage any investments for Commonfund (each, a “Manager”) or any fund managed by any Commonfund entity (each, a “Fund”). Accordingly, the views presented herein may not be relied upon as an indication of trading intent on behalf of Commonfund, any Manager or any Fund.

Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Fund. Such statements are also not intended as recommendations by any Commonfund entity or any Commonfund employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information or statements. Past performance is not indicative of future results. For more information please refer to Important Disclosures.