Investing in Emerging Market Currencies: A Rewarded Risk

Javier Corominas and Jonathan Scott

As emerging market (EM) countries converge in terms of productivity with the developed world, the associated currency appreciation, augmented by the carry available in EM currencies, forms a reliable source of return. According to our analysis, the returns to developed market investors from unhedged EM equity and fixed income investments can be explained largely by this currency return, although the implied currency exposures in these investments are in no sense optimal from a currency point of view. In this chapter, we will explain the drivers of EM currency returns, suggest reasons to consider EM currency as a stand-alone investment and ways to think about the construction of such an investment, and argue that there are plausible theoretical and empirical reasons to expect EM currency to generate persistent returns.

ECONOMIC RATIONALE BEHIND EM CURRENCY RETURNS

The economic theory supporting the expectation of a positive longterm return from investing in EM currency returns is underpinned by the Balassa–Samuelson effect, together with the forward rate bias (FRB). We explain both of these below.

The Balassa–Samuelson effect

Since at least the 1960s, econometric analysis has