Index hedging

Let’s look at a few global investment indices (stated in both USD and local currency terms) and see how their returns are affected by using two different dollar hedge instruments — the DXY and the Citigroup USD Flow-Weighted index (CFWI). Instead of reflecting the volume of physical trade between two countries, a flow weighted index reflects the volume of financial flows, which can be many times as large. The failure of physical trade balances in explaining currency movements has been the impetus behind flow weighting.

The goal of the analysis is to determine which one produces the lowest tracking error in converting the local currency index back into USD terms. Although the start date for the comparison is limited to the Jan. 4, 1999 introduction of the euro, an initial analysis of the dollar index’s effectiveness as a hedge can be started in January 1988 using the Dollar Index futures (DX) traded at the New York Board of Trade.

Using these futures also makes it possible to incorporate the interest-rate differentials between the U.S. and the DXY’s component currencies. The first market we can look at over the long-term sample is the Morgan Stanley International Europe, Australasia, and Far East (EAFE) index, a common benchmark for global fund managers. In USD terms the EAFE increased 232.2 percent over the period; its return in local currency terms was 234.0 percent. The hedged return — that is, the EAFE index combined with a long dollar index position — was 245.2 percent. It shows a similar comparison using the Morgan Stanley Emerging Market Free (EMKT) index. (A dual scale is needed to accommodate the effects of large-scale currency devaluations in many emerging markets over the analysis period.) Significantly, the six components of the dollar index do not represent any underlying emerging market asset, and yet the dollar index performs well in converting the EMKT in local currency terms into USD terms.

It shows the final equity comparison, using the MSCI World index (MXWD). Once again, an equity index hedged with a long position in dollar index futures provided superior results for an American investor.