Currency management is seen as integral to a portfolio’s total return. We believe that if a local bond market offers good value, the currency is likely to appreciate. However, there are situations when a currency may be undervalued or overvalued. In such situations portfolio currency exposures may differ from country exposures.
Forecasting currency movements consistently is impossible in our opinion. We, therefore, take a Purchasing Power Parity (PPP) valuation approach in order to gauge the fair value exchange rate of a currency. The PPP fair value exchange rate between two currencies is one that maintains purchasing power between them so that a basket of goods and services costs the same using either of the currencies. Since there are many influences on short term currency movements, actual exchange rates will deviate from these fair values. However, when those deviations become large enough that the currency is extremely over or undervalued then we may decrease or increase exposure to that currency.
When a bond market is overvalued but its currency is overvalued we will use defensive hedging. On mandates that are already currency hedged mandates, we may further add value by opportunistically removing hedges when currencies are extremely undervalued.