Defining FX Beta when treating currencies as an Asset Class

Dori Levanoni - is a Partner at First Quadrant. L.P

Given that Currencies are, therefore, an "Asset Class", can we define the Beta(s) behind the return to that "Asset Class"¹? Before we do that, though, we do have to come up with a working definition of "Beta".

What Is Beta?

An interpretation of Markowitz provides one useful definition (outside of Sharpe-Linter CAPM, which could be described as creating this same definition). Beta represents the return you bear for taking on non-diversifiable risk.

Note that it's not "the market" or "an index". It's "non-diversifiable risk". So, before we get too much further into the discussion:

Are US Equities² a Beta?

The short answer is "not really". Why? Because if I add US Treasuries to them, I can diversify away some (though not all) of the risk from holding another asset without removing return. The conclusion we draw from that observation is that US Equities are a "hybrid beta", in that the return of the market as a whole is composed of at least two entirely distinct betas (one called "Economic Growth" and another "Risky Asset").

The problem we face in looking at the return of US equities is that we can only see the Asset Class return and not the returns due to the Betas inside. We can, however, do some work to see the evidence of those Betas; the simplest way we've discovered is to answer the question:

What should the correlation between US Equities and US Treasuries be?

The answer is "zero"³, but looking just a little bit deeper into the question lets us refine that first answer to "it varies". And it's in that variation that we begin to see the Betas inside US Equities. The basic idea is that, when the World and Markets are quiet and calm, the "Economic Growth" beta dominates.

However, when the World and Markets aren't quiet, the "Risky Asset" beta dominates. So, in a quiet World, the correlation should be positive (since rising yields are bad for company profits and hence equity returns) whereas in a noisy World the correlation should be negative (since if you're worried, you sell Risky Assets⁴ and buy Safe Assets⁵).

Given that definition of Beta (and our one example), can we draw any conclusions about FX Beta(s)?

Is "Style" the same as "Beta"?

Since a Beta is earning a return from bearing a non-diversifiable risk, can a "Style" be a Beta? The debate is functionally the same as asking if "Value" (as a style of equity investing) represents a Beta or not? Note that "Style" here is effectively "Naïve Strategy" in meaning.

Fortunately, in the last decade a body of work (both academic and practitioner) has been produced on this very topic!

One of the earliest broad summaries is a paper published in 2005⁶ that looks at currency "styles" explicitly. Four such styles were identified in that paper: Value, Trend-Following, Yield, and Volatility Capture. The specifics of each of those "styles" are defined in that paper to a detailed enough extent that an interested reader (with access to the data) could recreate the returns at their leisure⁷.

There is one problem we'd point out, though. The definitions of those "Styles" are very idiosyncratic. For example, almost everyone who trades currency has heard of the "Carry Trade".⁸ But what exactly is it?

Perhaps the mostly commonly used definition of it is, "go long the high yield currencies and go short the low yield currencies." The problem is, that definition doesn't tell us how long/short to go, which currencies we should look at, what yields we should look at⁹ and even what "high" and "low" means. As a result, everyone's "Carry Trade" is different!

There are G-10 Carry trades that go long equal amounts of the three highest yielding currencies and go short equal amounts of the three lowest yielding currencies. On the other hand, the previously referenced paper sets the size based on how different the yield is from the average yield of all currencies included.

There are also Carry trades that only include emerging markets and others that include both G-10 and emerging market currencies.¹⁰ Others change the size of the "long" and "short" positions to adjust for the volatilities of the various currencies.

The one saving grace to the Gordian Knot¹¹ presented by all those variations of the Carry Trade is that they all do tend to have somewhat similar return patterns.

Some are even available on Bloomberg.¹²

Sadly, a few other trades also show similar return patterns, even though those trades have no currency component! A simple long US Equity trade or a long High Yield Corporate Debt / short US Treasury trade both show meaningful similarities to the return from the Carry Trade(s).

And, oddly enough, very few people seem to argue that US Equities (or "Credit" as represented by the second trade above) aren't Betas and so don't belong in portfolios!

In other words, just because we can't (yet) identify the underlying return source behind a return to a "Beta" doesn't mean it doesn't have one…

Funny Story

We might have made a tiny "error" in the chart earlier. The text might have led you to believe we were showing the performance of a Carry Index. Turns out, we weren't. It was, in fact, the S&P500 Total Return index. Here's the Carry Index chart with the same S&P500 Total Return index line overlaid.

Hard to tell the difference, right?

We'd chosen a particular currency "Style" that we knew, in advance, looked rather a bit like a non-currency program. And Carry should, fundamentally, have that relationship for a simple reason.

By going long the high yield and short the low yield, you're buying the risky asset (which therefore has a higher yield) and selling the safe asset (which therefore has a lower yield). Buying the S&P500 is buying a risky asset (and you're "selling cash" to fund the trade), so you're replicating the same "idea", but with a different set of assets.

And that ultimately is the point. It is the underlying idea (i.e. the Beta) that is the source of the returns, not the particular assets used to access that Beta. So, as long as you believe there are Betas in the World somewhere, you also have to believe there are FX Betas!

Do we care if there is/are FX Beta(s)?

Since we don't have a problem investing in US Equities even though they may/may not be a true Beta, we'd say we shouldn't really care if Currencies (or Currency Styles) are a true Beta or Asset Class either. In the end, we do care that we can construct portfolios through time that meet both our investment need(s) as well as our constraints.

Can currencies play a role in such portfolios?

So clearly, yes.

Our approach is to point out that the "price" of Currencies (i.e. exchange rates) is set in exactly the same way prices are set for other assets (i.e. stocks, bonds, commodities, etc.): someone bought or sold some.

And so, whether or not you can identify why they bought or sold, how much they bought or sold and what the price impact of their purchase or sale had doesn't change the fact that the price movements of currencies (or Currency Styles/Betas) look much like those of any other asset (or Asset Class) in portfolios.

In other words, we do care if there is/are FX Beta(s)…but we don't care if we know exactly what they are!¹³

Where to from here?

Once you accept that view, Currencies (and Currency Styles) can (and do) play a part in your portfolio just like any other "Asset Class". You can choose to accept the exposure or remove (i.e. hedge) it. You can allocate risk both to Passive and Active strategies in your portfolio¹⁴.

And, you can report on the impact both Passive and Active currencies/currency strategies have had on your portfolio.

There is one little question left to answer, though. What do you measure them against?

For Active strategies, the answer is fairly straightforward. What would have happened had you not invested in the strategy?

For Passive strategies, the question can be a little more complex, but since most investment pools exist to serve an identified purpose (i.e. Pension Funds servicing retiree benefits, Endowments servicing the organization, etc.), that purpose does have either an implicit (most common) or explicit (rare) currency component to it.

For example, if you are a Pension Fund, we'd ask, "What is the currency composition of your liabilities?" And that would be what we'd measure the Passive strategy against.

Finally

There are challenges facing both the definition and use of FX Betas (i.e. "Styles", etc.) in investment portfolios. But most of those challenges are no different than faced by other Asset Classes or Strategies.

Currency is almost certainly in your portfolio (if you invest or have liabilities outside your domestic currency) and it almost certainly represents a source of return that can either hurt or help your portfolio.

Don't ignore it, don't let the challenges turn you aside from facing the issues related to FX, since you've already overcome the same challenges when you looked at other Asset Classes!