Many investors are familiar with carry trades – trading strategies that exploit forward-rate bias (FRB) in currency markets. These trades entail going long higher interest rate currencies and funding these positions through lower interest rate currencies. A global currency strategy has produced consistent excess returns over the past twenty years, with many outperforming global stocks and bonds on a risk-adjusted basis. The chart (above right) shows how simple buy-and-hold strategies for oil, the S&P 500, and emerging market equity compare to a currency beta strategy. Bear in mind that these are equally risk-weighted, so the cumulative return comparison is legitimate.
We use the terms “international risk premium” (IRP) and “currency beta” synonymously. We believe the existence of such a premium is necessary for capital to flow across borders, out of economies where it is needed less, and into faster growing economies where it is needed more. IRP can be viewed similarly to the premium of corporate debt over government debt, or the premium of equities over bonds. As long as differences exist between the risk-reward relationships of assets in different countries – particularly real-rate differences – this premium will continue to be available.
There is a strong case for recognising this phenomenon as a risk premium, and not merely an occasional market anomaly. The thesis that this reflects compensation for risk is bolstered by a comparison of historical returns for IRP and those of other risk premia. If the returns are due to inefficiency in the currency forward markets, or some currency-specific anomaly, then they should not be correlated with assets that are rewarded in times of strong global economic growth. In fact, it turns out that carry trade returns are significantly correlated with the premium of corporate debt over government debt in countries all over the world, as well as global stock markets. During times of stress, the return profiles behave similarly.
There is also a strong relationship between credit default swap spreads and international risk premium returns since 2005. This suggests that a large portion of carry returns are explained by changes in the market price of global government credit risk.
Given that IRP is a compensation for risk – in other words, an asset class – it is natural to ask how one can integrate it into a typical institutional portfolio of stocks and bonds. IRP wins capital predominantly at the expense of the corporate bond allocation, and can merit a similar weighting to corporate bonds due to their positive correlation and similar risk profiles. The expected performance of the overall portfolio improves due to both the diversification benefits of adding a new asset class, and the excellent return characteristics of IRP strategies.
If one prefers to avoid asset substitution, one should remember that any currency strategy is a zero-investment strategy – in order to buy one currency, you must sell an equal amount of another. Thus, the IRP is available without any additional capital, through leverage. Such an approach would allow investors to benefit from the consistent return stream of an overlaid currency program, and reap the benefits of diversification, without having to alter significantly the composition of their existing stock and bond portfolios.