Don’t Forget About Currency


One of the most important factors to consider when investing in Frontier Markets is the currency impact on your investment.  Whether you hedge or remain unhedged, you are taking a position on the currency.  Frontier Markets add further complication due to the fact that hedging instruments on many of these currencies are illiquid and in some cases, may not exist.  While forward prices are based on interest-rate parity, neither interest-rate parity nor purchasing power parity has proven valid in Frontier Markets over the medium and long-term.  Inflation and interest are important determinants, no doubt, but the relationship is far from the simplistic one that interest rate parity implies.

Table 1: USD v. local currency returns for selected markets
Table 1: USD v. local currency returns for selected markets

Looking at a few Frontier Markets over the past year, you can see that currency can significantly alter the return profile of an investment. (Table 1)

Ghana experienced the most significant change; the Ghanian Cedi (GHS), depreciated 17.2% relative to USD this past year, and this made the strong local currency return of 23.8% a disappointing 6.6% in USD terms.  This should be contrasted with Pakistan, where the Pakistani Rupee (PKR) depreciated 11.2% relative to USD, but till provided a USD-return of 37.8%, more than enough to make up for the increased risk of investing in Pakistan.The one country which deserves special mention is the Philippines.  Since 2005, the currency has appreciated relative to USD in 5 of 7 years.  Investing in the Philippines’ equity market in 2005, would provide you with a return of 337.2% in USD terms, and only 219.1% in Philippine Peso (PHP) terms at the end of 2012.

The Philippines can be contrasted with Nigeria, where investing in 2005, would provide  you with a return of 2.8% in USD terms and 21.3% in Nigerian Naira (NGN) terms at the end of 2012.  Over the same time period, the S&P 500 provided a return of 40.1%.

Finding quality companies should always be the first priority, but how you value the cash flow of each company should have an embedded view on currency which reflects your view and analysis of the particular country’s currency.   A well-formed view on currency should consider FDI, the current account of the country, tax collection rates in the country, government stability, inflation, and growth prospects.

Always keep in mind, what is practical from a hedging perspective.  If forwards or futures are not available to you, consider and study alternative ways to hedge (using ETFs that share a similar relationship to the currency, in the case of Chile for example, a Copper ETF, or use a local company which benefits from a currency depreciation that is also reasonably attractive.  As an example, an exporter whose inputs are purchased or produced locally).

Equity investors have long ignored currency to their own detriment, if you are able to successfully integrate currency into your investment process you will be able to reduce risk in your portfolio and improve your analysis of investments.

Further Reading:

A good piece on using WACC for Frontier Markets, I apologize for the formatting, but if you have a ‘reader’ extension for your browser, you should be okay: The Weighted Average Cost of Capital in Frontier Markets




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