Tail risk hedging your portfolio using currency
In a recent paper co-authored by staff from the Bank of England and the European Central Bank (ECB) on currency tail risk highlights how Australian investors can find the best ‘safe haven’ currencies whilst also identifying those that are ‘risky’.
The Australian dollar remains top of ranking in terms of an increased likelihood of a sharp depreciation (large downside entropy, in other words a measure of information), while at the opposite end of the spectrum there are a series of currencies with large upside entropies that behave as ‘safe havens’, notably the Swiss Franc, Japanese Yen and the USD.
Jamieson Coote Bonds (JCB) has long believed that one of the best negative correlation assets for AUD based investors is US denominated high grade fixed income. From top to bottom in the GFC, such a holding produced staggering returns for AUD based investors (positive ~70%) whilst risk assets melted around them (minus ~39%).
The ‘entropy’ of these assets is all important when building tail risk solutions, identifying in which direction they have historically slingshot under market stress. As seen in the chart below, in the face of tighter global financial conditions (market stress), the likelihood of observing a sharp appreciation (right tail) in the Swiss Franc, Yen and USD goes up significantly, while in the case of the Australian dollar it is the likelihood of a sharp depreciation (left tail) that goes up markedly.
A quantification of the sharp appreciation and depreciation risks
Market returns over 2019 have skewed many tactical asset allocations with large equity moves lifting asset weightings. As we look ahead into 2020, it is a natural time to consider optimised allocations and return to structured investment process for disciplined investors. Tail risk hedging and negative correlation allocations aren’t particularly exciting, but for those that are looking for more certainty of outcomes, building out left tail protection ahead of time remains a critical part of portfolio planning.
Powerful left tail solutions via active currency allocations
Adding active currency allocations with fixed income can provide powerful left tail solutions. It is important to note that this combination brings more volatility than a domestic fixed income only ‘defend and protect’ allocation, but as the above shows, historically that volatility works in your favour in times of stress making it a great left tail hedge.
As investors think through this it is also worth pointing out that JCB believes this combination will work well under any Australian Quantitative Easing program which would target the AUD materially lower.
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 Attention to the tail(s) global financial conditions and exchange rate risks: https://bankunderground.co.uk/2019/12/17/attention-to-the-tails-global-financial-conditions-and-exchange-rate-risks/
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Charles is a co-founder of Jamieson Coote Bonds (JCB) and oversees portfolio management of the Australian and Global High Grade Bond and Dynamic Alpha investment strategies. Prior to JCB, Charles forged a career as a seasoned bond investor from...