Currency effects on emerging-market returns: local, dollar and euro returns, long-term depreciation and the cost of hedging

What you will learn

• The three layers of an emerging-market return for a euro investor and the formula that links them.
• Why many emerging currencies depreciate for decades and how to estimate the drift.
• How interest-rate differences set the cost of a currency hedge.
• A practical rule for deciding whether to hedge emerging-market exposure at all.

Explanation

How exchange rates change the euro return of a foreign investment was introduced in "Forex & Currency Trading in Depth" (lesson 11), and purchasing power parity in lesson 5 of that course. This lesson applies both to emerging markets, where the effects are larger.

Three layers of return

Most emerging-market indices are published in local currency, in US dollars and in euros. For a euro investor the chain is:

(1 + R_EUR) = (1 + R_local) × (1 + FX_local/USD) × (1 + FX_USD/EUR)

where FX_local/USD is the percentage change in the value of the local currency against the dollar (negative if it falls) and FX_USD/EUR is the change in the value of the dollar against the euro. The dollar layer is shown separately because fund reports and index factsheets are mostly in dollars, and because the dollar often moves against both the euro and emerging currencies at the same time. Consequence: when the dollar strengthens against emerging currencies (common in risk-off phases) but also against the euro, the two currency layers partly offset each other for a euro investor.

Why emerging currencies tend to depreciate

Over long periods exchange rates drift towards the inflation differential: a country with 8 % inflation against 2 % in the euro area tends to see its currency lose roughly 6 % per year against the euro (relative purchasing power parity). Around that drift the real exchange rate swings for years. A nominal local-currency return in a high-inflation country therefore overstates what you will keep; look at the euro index.

What a hedge costs

Currency hedges use forward contracts: an agreement today to exchange currencies at a fixed rate on a future date. The forward rate is not a forecast. By covered interest parity it follows from the interest-rate difference:

Forward ÷ Spot ≈ (1 + r_EUR) ÷ (1 + r_local) for one year, in euros per unit of local currency.

If the local one-year rate is 11 % and the euro rate 2 %, the forward price of the local currency is about 8 % below spot. Selling it forward locks in a loss of about 8 % per year relative to today's rate. That is the hedging cost, roughly the interest-rate differential; you earn it back only if the currency falls by more than that. For developed currencies with similar rates hedging is almost free; for high-rate emerging currencies it is not.

So should you hedge?

Rules of thumb used by many professional allocators: (1) do not hedge emerging-market equities; the cost is high, equity volatility dominates anyway, and hedged EM equity share classes are rare and expensive. (2) For emerging-market bonds, choose the currency deliberately: hard-currency bonds (dollar risk only, cheap to hedge) or local-currency bonds (left unhedged, because hedging would remove most of the extra yield). (3) Treat the dollar layer as one decision for the whole portfolio, not per fund.

Worked example

Hypothetical example: you hold a fund on the stock market of "Alvania" (invented) for one year. Local index return +18 %; the Alvanian currency falls 12 % against the dollar; the dollar falls 5 % against the euro. Local one-year rate 11 %, euro rate 2 %. Fees, spreads and taxes are ignored.

Step 1, dollar return: 1.18 × (1 − 0.12) = 1.18 × 0.88 = 1.0384, so +3.8 % in dollars.

Step 2, euro return: a dollar that fell 5 % against the euro buys 1 ÷ 1.05 of the euros it did before, so 1.0384 ÷ 1.05 = 0.9890, that is −1.1 % in euros. An +18 % local year became a small loss for you.

Step 3, with a full hedge of the local currency into euros: forward ÷ spot = 1.02 ÷ 1.11 = 0.9189; hedged return ≈ 1.18 × 0.9189 = 1.0843, about +8.4 %. The hedge gave away 8.1 percentage points relative to an unchanged exchange rate but protected you from the larger actual fall: the local currency lost 1 − 0.88 ÷ 1.05 = 16.2 % against the euro.

Step 4, ten-year drift: if Alvanian inflation stays at 8 % against 2 %, relative purchasing power parity implies a euro value of the currency after ten years of about (1.02 ÷ 1.08)10 = 0.565, a loss of roughly 44 %. A local index would need to gain about 77 % (1 ÷ 0.565 − 1) over the decade just to stand still in euros, before costs. Figures rounded to one decimal.

Common mistake

Practice activity

On paper: a local index returns +25 %. Its currency falls 20 % against the dollar, and the dollar rises 3 % against the euro. Local one-year rate 14 %, euro rate 2 %. Calculate (a) the dollar return, (b) the euro return, (c) the approximate return with the local currency fully hedged into euros, and (d) say in one sentence whether hedging would have helped.

Key takeaways

• Euro return = local return × local-currency change × dollar change; check all three layers before judging an emerging-market fund.
• Over decades, high-inflation currencies drift down roughly by the inflation differential; nominal local returns overstate what you keep.
• Hedging cost ≈ interest-rate differential; for high-rate currencies it can eat most of the expected extra return.
• Common practice: leave EM equity currency unhedged, decide dollar exposure at portfolio level, choose hard- or local-currency bonds deliberately.

Next step

Next you will compare the practical ways to buy emerging-market shares from Germany: ADRs, GDRs, local listings and the limits of German brokers.