International Investing: Currency Risk in Equity Portfolios

As investors increasingly use international diversification to improve their equity portfolio returns, the understanding and management of currency exposures takes on ever greater importance.  While equity managers are generally comfortable analysing their portfolios for equity-specific risks, such as sector, style or factor biases, for many investors, exchange rate risk remains an area of limited expertise.

This report shows how equity index futures provide investors a more flexible alternative to cash equity market products for managing the foreign exchange risks inherent in international equity index investments.  This is illustrated with the specific case of a fully-funded non-U.S. investor gaining exposure to the S&P 500 via both CME E-mini S&P 500 equity index futures and exchange-traded funds (ETFs).

Funding a Foreign Purchase: To buy or to borrow?

As compared with domestic investing, investors in foreign equity markets take on additional risk related to fluctuations in the exchange rate between the currency of the asset and their home currency.  The magnitude of this risk depends on whether the investor buys or borrows the amount of the foreign currency needed to purchase the asset. 

With a cash equity market product, such as an ETF, the investor must buy the foreign currency in order to purchase the shares.  This results in an exchange-rate exposure equal in magnitude to the notional value of the position.  With futures, the foreign currency is (implicitly) borrowed which limits the magnitude of the currency exposure to the profit or loss on the position only.  Figure 1 summarizes the results of the hypothetical example which will be used to illustrate this.

Figure 1: Euro-Based Investor Purchasing €100M of S&P 500 Exposure via ETFs and Futures

ETF: Buying the foreign currency

With a cash equity market product, such as an ETF or equity share, the full purchase price of the security must be paid to the seller at the time of trade.  An investor with a standard custody account (i.e. not a prime broker) must first buy the necessary amount of foreign currency and then use these foreign currency units to purchase the share.

Consider, for example, a fully-funded EUR-denominated investor who wishes to invest €10M in the S&P 500 through the purchase of a USD-denominated ETF.The investor has the €10M funds available and executes the trade in two steps:

  1. Purchase USD:  Sell €10M EUR and purchase $10.80M USD at an initial EUR exchange rate of 1.080 USD per EUR.
  2. Use USD to buy ETF:  Use the $10.80M USD to purchase 46,000 shares of the ETF at $234.80 / share.

These transactions are summarized in Figure 2.

Figure 2: Decomposition of Transactions for ETF purchase

From a starting point of holding €10M EUR, the investor now holds 46,000 shares of the USD-denominated ETF on the S&P 500.  The decomposition of the trade into two steps illustrates the “double-barrelled” exposure the investor has made.  The first step is a pure currency trade: the investor purchases $10.8M USD versus selling EUR.  The investor is long the dollar – the value of this position rises if the USD strengthens versus EUR and drops if the home currency (the euro) strengthens.  In step two, the investor converts this long USD position into another USD-denominated asset – this one linked to the equity market: an ETF on the S&P 500.

This long ETF position is, from the perspective of the EUR-based investor, a combined currency and equity asset.  These dual sensitivities become apparent when examining the gains and losses experienced by the investor when either the ETF or the currency moves.  This is illustrated below in Figure 32.

  • Case 1:  Equity market rallies / euro unchanged:  If the S&P 500 rallies by 10%, the price of the ETF will increase from $234.80 to $258.30.  This 10% rally results in a 10% positive gain on the position, in this case equal to €1M EUR – identical to what would be experienced by a domestic investor.
  • Case 2:  Equity markets unchanged / euro strengthens:  If equity markets remain constant (ETF stays at $234.80) and the euro rallies from 1.080 to 1.200 (i.e. it takes an additional $0.120 to purchase €1), the investor shows a loss of 10% on the position due to the long USD / short EUR exposure.3  If the investor were to close out the position by selling the ETF at the same $234.80 purchase price, and then convert the $10.80M back into EUR at 1.200 USD / EUR, they would end up with only €9M – a €1M loss with no equity movement.
  • Case 3:  Both equity market and euro strengthen:  If both the S&P 500 and the euro rally, the investor gains on the equity market rally, but loses on the currency move.  Observe that under this combined scenario the investor experiences a net loss of €100,000 despite the fact that when the equity and currency moves are considered separately the gain on the equity (+$1m, in Case 1) is equal to the loss on the currency (-$1m, in Case 2).  This is because the size of the long USD position has increased by 10% due to the rally in the S&P 500.  This creates an incremental €1m EUR of long USD exposure on which the investor loses 10%, resulting in a net loss of €100k.

Figure 3: Sensitivity Analysis of ETF Position

The fully-funded nature of ETFs requires that the investor take on this double risk exposure on both the underlying equity market and the foreign currency.  For an investor seeking a pure equity-market bet, this exposure can be problematic.  In case 3, for example, the investor made the right call on the direction of the equity markets, but their profits were more than offset by the loss on the currency move. 

Futures: Borrowing the foreign currency

With futures contracts, the buyer and seller do not exchange cash at trade initiation.  Rather, both parties post performance bond, also known as margin, with the clearing house and fund the trade independently.  CME Clearing is responsible for setting the margin on USD denominated S&P 500 futures and calculates performance bond requirements by analysing the “what-ifs” of virtually any market scenario.  CME’s Standard Portfolio Analysis of Risk (SPAN) system for calculating margins is widely accepted as the industry standard.  CME Clearing is able to accept margin collateral in multiple currencies.  This allows the investor to take on the equity exposure without first having to purchase the foreign currency.  This greatly reduces the exchange rate exposure of the position.

To make the comparison with a cash equity market product easier to understand, it is useful to express a futures position in terms of the equivalent cash equity transaction.  The returns of an index futures contract can be precisely replicated by borrowing the necessary amount of cash and purchasing the replicating stock portfolio of the index.  This is the basis for the calculation of futures fair value and of the arbitrage that keeps futures markets trading in line with the index. 

In the analysis that follows, futures positions are represented as the combination of:

  1. A fully-funded long position in the pure index return – as though one could “buy the index”
  2. The amount is expressed in USD units, similar to how a swap might be quoted
  3. A short position in the amount of foreign currency (i.e. a loan) required to purchase the long

In this case, the foreign currency will be USD, as we are writing from the perspective of a euro-based investor. 

Figure 4: Decomposition of Transactions for Futures Purchase

Because the futures contracts are self-funded, the replication of the S&P 500 now consists of a single step.  The investor holds onto their €10M EUR and purchases the index futures, which is expressed as the simultaneous purchase of a long index position and a short of the equivalent notional of USD.  This is shown in Figure 4.

As compared with the fully-funded case, the investor now has three positions – two long (EUR and SPX), and one short (USD).  From the perspective of a EUR-denominated investor, however, the value of€10m EUR is a constant and this position can be ignored in the sensitivity analysis. 

The investor is therefore long the fully-funded S&P 500 index, and short USD.  This long index position has the same “double-barrelled” risk as the ETF did in the previous example – it is a combined equity and currency position.  However, the currency exposure of this position is now offset by a short position in a pure USD asset.  Changes in the exchange rate between U.S. dollars and euros impact the long and short positions equally, and the changes cancel each other out.  The investor’s initial position has no currency exposure. 

It is only when the size of the long exposure changes (due to movements in the underlying equity index) that the investor’s currency hedge becomes imperfect – the size of the currency exposure from the combined equity and currency position is different from the size of the short currency position.  The investor does have exposure to exchange rate fluctuations, but only on the gains or losses due to equity movements, not on the base notional amount. 

Applying the same index and currency movements from the previous example illustrates this.

  • Case 1.  Equity market rallies / euro unchanged:   As with the ETF, the position gains 10% in value (equal to €1.0M) if the underlying index rallies by 10%. There is no change in the value of the short USD position.
  • Case 2:  Equity markets unchanged / euro strengthens:   If the EUR rallies 10% from 1.080 to 1.200, the €1.0M loss on the value of the long index position is offset by a profit of €1.0M on the short USD position.  From the perspective of a euro-based investor, the strengthening of the currency means that the $10.80M USD that was borrowed to fund the purchase of index exposure (and must subsequently be returned) is now worth €1.0M less.  This gain offsets the equivalent loss on the long S&P 500 position.   Where the ETF investor took the full impact of the currency move, losing €1.0M, the futures investor has zero gain or loss on the position. 
  • Case 3:  Both equity market and euro strengthen:  If both the S&P 500 and the euro rally, the investor gains on the equity market rally, but loses on the currency.  The currency loss on the initial notional amount of €10M EUR is offset by the short currency position.  However, because the short USD position does not increase in size with the move in the equity market, the €1M EUR gain on the long position is exposed to currency fluctuations.  As such, the 10% strengthening of the euro costs the investor €100k on the €1.0M gain, resulting in a net positive return of 9.0%, as opposed to the desired 10%.

These three cases are illustrated in Figure 5.

Figure 5: Sensitivity Analysis of Futures Position

As compared with a fully-funded ETF, equity index futures significantly reduce the non-USD investor’s exposure to currency fluctuations.  Moreover, international investors in U.S. markets can always choose to convert a part or all of the uninvested cash into USD if they wish to take on both exposures.  The currency exposures are linked with ETFs, while with futures the investor can manage the magnitudes of the two risks independently.

Futures: Interest Rate Exposure and Margin

The buyer of an equity index futures contract gets index exposure without having to put up the full amount of cash to pay for it.  As a result, the pricing of the contract contains a component which represents the interest charges paid by the long holder on these implicitly borrowed funds.  In the case of the E-mini S&P 500, this implied interest rate is generally based on 3-month USD Libor. 

For a fully-funded USD-based investor who retains the uninvested cash on deposit, the interest rate implied in the futures price is offset by the interest earned on the deposited cash.  There may be a funding spread between the borrowing and lending rates but the base interest rate exposure is hedged.

By contrast, a fully-funded non-USD investor who puts their uninvested local currency on deposit will receive a local interest rate.  This creates two potential sources of exposure.  Firstly, there is the difference between the interest rate paid on their home currency and the 3m USD Libor rate implied in the futures.  Secondly, there is exchange rate risk due to the fact that the currency in which the interest is earned is different from the currency where interest is being paid (U.S. dollars). 

The significance of these exposures depends on the difference between the interest rates of the two currencies.  In the example just presented, their impact is minimal:

  • The interest rate differential between 3m USD Libor and 3m Euribor is approximately 1.50%, which represents a €150,000 per annum cost to the EUR-investor (due to the lower rate earned on EUR).
  • The exchange rate risk on this amount, under the same 10% move from 1.080 to 1.200 USD per EUR, is €15,000 or 0.150%, and in this case partially offsets the loss due to the interest rate differential. (The euro strengthening reduces the size of the USD interest payment liability).

However, in those cases where the interest rate differential is more significant, the potential benefit from index futures is magnified.  If instead of a euro-based investor, the same scenario is analysed from the perspective of a Mexican peso-based investor, the results are very different.

Short term interest rates in Mexico are approximately 6.00%, as compared with 1.15% on the U.S. dollar.  The amount of interest earned on the local currency deposit is therefore far greater than what is implicitly charged on the futures.  In the absence of any currency movements, a MXN-denominated investor in ES futures would outperform the USD-denominated investor by greater than 4.50%. 

Margin

At time of writing (March 2017), the margin requirement on an E-mini S&P 500 futures contract is approximately 5% of the notional value of the position.  This amount can be posted to the clearing house in US dollars or alternatively in any of 19 other major currencies4.  For those non-USD investors whose local currency cannot be posted as collateral, 5% of the trade notional value will need to be converted from their local currency into USD to be posted as collateral.  The investor would then be exposed to currency fluctuations on this margin amount, while the other 95% can be kept safely in their home currency.  The currency exposure for these investors is therefore a 5% / 95% blend of the two idealized scenarios originally presented.

Other Possibilities

While cash equity products, such as ETFs, and equity index futures illustrate the two most commonly-used listed vehicles used by non-U.S. investors to gain broad equity market index exposure, there are other funding alternatives and products that allow investors different ways to manage their currency risk.

  • Prime Broker Funding:  One of the services prime brokers offer their clients is leverage.  When purchasing a fully-funded product (such as an ETF or equity share) denominated in a foreign currency, the investor can borrow the required amount of currency from the prime broker, and post their own cash and other securities as collateral.  This limits the currency exposure to the gain or loss on the trade, similar to a futures contract.  In return, the prime broker charges the buyer charges an interest rate to the borrower of funds.  In the United States, Federal Reserve Board Regulations T and U cap the maximum amount of leverage that can be offered to investors at levels well below what is available with futures.
  • Foreign-listed ETFs:  There are S&P 500 ETFs listed outside the U.S. in currencies other than the USD.  In Europe, for example, there are S&P 500 ETFs listed in EUR, GBP and CHF.  However, these funds provide exactly the same currency exposures as the U.S.-listed ETFs that trade in USD.  The only difference is that the fund manager accepts the foreign currency as payment for the ETF and then does the FX conversion itself, rather than requiring the client to pay USD up front.  These funds also usually carry a significantly higher expense ratio.  For example, the iShares U.S.-listed S&P 500 ETF, the IVV, has a management fee of 4bps while their European-listed IUSA fund on the same benchmark has a management fee of 40bps.
  • Currency-hedged ETFs:  There are ETFs that use a combination of foreign exchange derivatives (such as futures, forwards, swaps and options) and outright foreign currency transactions to reduce the exchange-rate exposure of the fund.  The performance of these funds will depend on the frequency with which the currency hedge is rebalanced and is not the same as what would be accomplished with a leveraged position accomplished either through futures or a prime broker cash loan.  These funds generally have expense ratios that are higher still than the unhedged foreign-listed funds.
  • FX futures:  For investors who prefer to manage their currency risk themselves, CME Group offers futures contracts on currency pairs which can be used to hedge the exchange rate exposures inherent in a portfolio of cash market products such as ETFs or single stocks.5
  • Quanto:  With futures it is also possible to eliminate the exchange rate risk entirely.  The CME’s USD-denominated Nikkei 225 contract is defined to be $5.00 times the level of the Nikkei 225 index.  The contract implicitly fixes the JPY/USD exchange rate at 1.00 by having the final USD settlement price be equal to the observed Yen Nikkei 225 SOQ level at expiration. The transposing of the Yen SOQ level to a USD final settlement price on this one-to-one basis establishes the quanto relationship that provides the USD-based investor the same currency-free market exposure as a local JPY-denominated investor. While the hedging transactions for the arbitrage community are more complex, the contract enjoys over $6bn in open interest and $1.7bn per day in trading.

Conclusion

Currency exposures are an inescapable part of global investing.  As investors come to view international diversification not as a “nice to have” but as a core characteristic of their equity portfolio, asset managers of all sizes need to understand how to measure and manage foreign exchange risks.

Equity index futures allow foreign investors to manage their equity and currency risks separately.  ETFs, by comparison, provide a combined equity and currency bet which can only be undone through broker leverage, currency overlays by the fund manager or additional currency hedge transactions by the investor.

As was shown in the recently published report “The Big Picture: A Cost Comparison of Futures and ETFs”, futures provide a more cost-effective implementation tool for equity index investing across most scenarios. In particular, the impact of dividend taxation makes futures a significantly less expensive means for foreign investors to replicate the S&P 500 as compared to ETFs.

The only exception to this was in the case of a U.S. tax-exempt investor.  The analysis in this report, however, shows that even for this community of investors, the efficient management of foreign exchange risk provides an additional reason for non-U.S. investors to look closely at index futures when making their implementation decisions. 


1 In the examples that follow, certain aspects of both futures and ETFs (e.g. ETF management fees, futures multipliers) are deliberately simplified to focus attention on the currency-specific aspects.  These simplifications do not change the results of the analysis.  

2 In this example, the ETF management fee, dividends and any other tracking risk is ignored and the fund is assumed to move exactly 1-for-1 with the underlying index.

3 The reader may notice that the change in the value of the Euro of $0.120 is actually 11.1% of the initial exchange rate of 1.080 USD / EUR.  Why then is the loss on the trade 10%?  The reason is that while most global currencies are quoted in terms of foreign currency units per USD, the EUR is one of the few currencies which quotes as the number of USD required to purchase one EUR.  Because of this convention, the EUR value column in Figure 3 is computed by dividing by the exchange rate.  If the initial and final exchange rates are re-expressed in terms of EUR per USD, the change – from 0.926 to 0.833 – is in fact equal to 10%.

4 The margin requirement on E-mini S&P 500 futures is 4.6% at time of writing. Non-USD cash and other non-cash collateral (e.g. bonds, equities) are subject to haircuts. Margin amounts are subject to change. Details available at http://www.cmegroup.com/clearing/files/acceptable-collateral-futures-options-select-forwards.pdf

5 For more information on CME Group FX products, visit www.cmegroup.com/trading/fx

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