Emerging Market Currency: The Common Risk Factor in Emerging Markets

Abstract

In this note, we argue that the set of available EM investment options, both debt and equity, share a common risk factor that drives most of the EM-related risk and return. We demonstrate empirically that this common risk factor is best represented by EM currencies. This has an important implication for investors: while conventional wisdom argues against hedging currency exposure across the different EM investment choices based on the transaction costs involved in hedging such exposures, then the existence of a dominant common risk factor may be an argument for hedging to achieve diversification among different types of EM investments. We would argue that this should not be the case. Hedging EM currency exposure in any type of index leaves very little actual EM exposure in the investment. Rather, hedged EM equity indicies only provide (expensive) developed equity market exposure, while hedged EM fixed income exposure only provides (expensive) developed market fixed income exposure with, in both cases, little idiosyncratic EM risk. We would argue that embracing the common risk factor found in EM currencies is one of the strongest choices for investors seeking general “EM exposure” while simplifying market accessibility.