Clmann at gic new york to post

Perspectives on EFT and EME Currency Risk: Good, Bad, Ugly

Dr. Catherine L. Mann Barbara 54 and Richard M. Rosenberg Professor of Global Finance International Business School, Brandeis University www.CLMann.com

Managing Currency Risk in the ETF Space Global Interdependence Center

New York Athletic Club * May 19, 2014

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What’s Being Managed?

• Currency risk – Sigma (volatility within bounds) – Kurtosis (rare event out of bounds)

• Currency exposure – Financial transactions (asset) – Real sector performance • exporter, importer, domestic, supply chain 2

History Lessons: Origins of Currency Crises !"#$%&'()*"!+),"-.& !""#$%&'(")*#$&$+" !""2'/3")*2+ !"",-$.$/'("%$/"

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3 Â

Lessons of Currency Crisis History • Equity not at the center of crisis (generally) – Shared risk by investor, borrower – But, beware equity-­‐to-­‐bank balance sheet exposure

• Originate/syndicate tends to overexpose – Lays off risk, but poten@al moral hazard – Weakens ‘due diligence’, both originator & investor – Adding-­‐up fallacy – individual fund is ‘not small’

• Network/herding/bailouts worsen crises – Asset/balance sheet linkages exacerbate – Self-­‐fulfilling herding propagates – Bailouts shiM risk from private to public

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Relevance of History Lesson for Emerging Market ETFs? Some testable hypotheses

• RelaEvely few listed firms – Poten@al for concentrated porPolio

• MulEple ETF in same equity space – Limited absorp@ve capacity by firms – Poten@al cross-­‐fund aggrega@on issue

• Asset to fund flow valuaEon feedback – Exacerbate currency / stock index moves

• Equity in SOEs – Poten@al for sovereign bailout feedback

5

Overall Picture of EME Capital Flows

Bluedorn, Duttagupta, Guajardo, Topalova, “Capital Flows Are Fickle….” IMF WP13/183 (Aug, 2103)

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Equity EFTs: Selected Countries a meaningful share of US equity allocation strategy EF?<&37%-;&49&G3&EH5$6B&8<<;6&C4/#$"D<& 'G3&<7%-;&$"&I45"6-B&?46%/&J%-A;6&I%K)&I45"6-B&L%"A&$"&M/4N%/&J%-A;6+& '!"!# &$"!# &!"!# &!!(# &!!)#

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ETF flows, number of listed firms: Bloomberg. A superior indicator of concentration and absorptive capacity would be ETF fund flows into specific equity assets and distribution of $ flows by specific 8 equity asset.

Potential Feedback Loop:

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9 Major stock market index for specific country; other indexes not appreciably different

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Fund Flows and Currency Risk "#)%

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Nega@ve correla@on: Fund inflows (ouPlows), appreciate (depreciate) home currency.

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Potential Feedback Loop:

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Nega@ve correla@on: Home currency depreciate (appreciate) Stock index falls (rises) 11

Which Currency Risk to Manage?

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Month-­‐to-­‐month percentage change in home currency. Trend deprecia@on for all currencies except Thailand.

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Which Currency Exposure to Manage?

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Currency strategy to hedge financial transla@on transac@on is unidirec@onal; Currency strategy to hedge real sector performance depends on type of external exposure of the firm.

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Summary Observations • ETFs size: Asset Holdings/Market Cap – On the map for US asset alloca@on (10% or more) – S@ll small (1% or less) of market cap for countries

• ETF Fund Flows and feedback loops – Significant for currency and stock market moves for this sample of countries – Generally not stabilizing for this country sample

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Lessons from History: Implications for Management • Few listed firms ó Accentuate asset/currency moves – EFTs chasing same firms – Macro/cross-ETF aggregation issue – Exacerbates disconnect betw equity/asset measure and real sector/firm performance • Implications for managing currency risk?

– Objective? Real performance vs. financial performance • Investment in country firm vs. trading in country asset markets

– Policy? Financial objective + positive feedback loops • Policy response of asset market regulations is not unreasonable 15

Thank you! Ques@ons?

Excellent Research Assistance from Chinmayee Atre and Xioalin Zhang

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