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Investors often underestimate the scale of their forex exposure. Amid heightened political risk and new technologies, navigating these markets requires a rethink.
Heightened currency risk
Equity volatility dropped to its lowest level in more than two decades this July, as measured by the VIX ‘fear gauge’. But while stock markets seem to be in a state of Zen-like calm, political risk has soared — hitting investors via currency markets in particular.
The shock UK referendum vote to leave the EU last year precipitated the biggest fall by one of the world’s four major currencies since the 1970s, when free-floating exchange rates were introduced. Sterling came under renewed pressure this June after another against-consensus result in the UK general election.
In the US, Donald Trump’s surprise presidential victory sent the Mexican peso to record lows against the dollar and other emerging currencies tumbling. There have been near-misses for forex markets recently, too: Emmanuel Macron’s win over far-right candidate Marine Le Pen in France’s presidential election may have saved the euro altogether.
A new normal?
Some have argued that unpredictable politics has become the new normal, partly because social media has fragmented political discourse and encouraged ideological tribalism — with knock-on effects for currency risk.
“Everyone has foreign exchange exposure, even if they don’t realise it,”
says Martin Hirlemann, Head of Foreign Exchange EMEA at Deutsche Bank Wealth Management. That exposure is increasing in parallel with investors’ growing enthusiasm for international portfolios. Home bias among US investors, for instance, declined 10 percentage points between 2004 and 2014.
Even high-net worth individuals — who have always tended to lead international lives — often underestimate their foreign-exchange risk.
“As well as having global investments, many of our wealthy clients have complex currency exposures through business interests and property portfolios,”
says Nick Stone, Global head of Capital Markets at Deutsche Bank Wealth Management. “These are often significant, but they can be difficult to quantify.”
Measuring currency risks associated with businesses is particularly challenging. According to a 2016 survey by Deloitte, 60% of global businesses say they struggle to quantify their currency exposure due to a “lack of visibility over FX exposures and of reliable forecasts”, among other factors.
Even for those able to gauge their currency risk, hedging it efficiently is not always easy. Foreign exchange is by far the largest financial market, with about $5 trillion traded during the market’s 24-hour cycle. Yet its decentralised nature means participants may have to shop around to get the best price.
“Forex markets are underpinned by a relatively small number of financial institutions,” explains Stone. “The price they’re willing to trade at depends not only on macro factors, but on the positions they happen to be sitting on as a result of their business activities. That’s why prices can vary significantly between institutions.” Deutsche Bank Wealth Management offers an ‘open-architecture’ foreign-exchange service, sourcing prices from 15 market-makers for its clients.
Nowhere to hide
Navigating currency markets has arguably become more complex because they are changing: for one thing, new technologies — such as peer-to-peer exchanges — are transforming the ways some participants transact; for another, regulatory reform has discouraged market-making banks from holding as much forex risk.
Yet according to Hirlemann, that is no reason to be deterred. “Given that currency risk is ubiquitous, we advise clients to take an active approach — especially given recent market shocks,” he says.
“Whether you’re hedging, making a transaction, or using currency as a source of potential investment returns, we prefer to see forex as an opportunity rather than a problem to hide from.”
With one of the world's largest foreign exchange platforms, Deutsche Bank assists private clients in all aspects of currency management, including hedging, trading and investing. To discuss your requirements, we invite you to contact your Deutsche Bank Client Advisor.