Which currency to use?

If anything can be learned from more than three decades of flexible exchange rates, it is that non dollar cross-rates are as unpredictable as outright transactions against the U.S. dollar (USD). This is evident, which is a matrix showing the correlation of returns between the benchmark dollar index (DXY) and its six component currencies — the euro, Japanese yen, British pound, Canadian dollar, Swiss franc, and Swedish krona.

An investor holding a multiple currency investment portfolio and seeking protection against a stronger dollar must choose a hedge instrument from a group of unsatisfying currencies. The euro (EUR), which comprises 57.6 percent of the DXY, clearly is the most negatively correlated against the USD, but at 0.94, the tracking error could be considerable.

The correlations drop off considerably after that: The Japanese yen (JPY) and Canadian dollar (CAD) have negative correlations of only -0.501 and -0.381, respectively. Within the correlation table for cross-rates, only the Swiss franc (CHF) and Swedish krona (SEK) have correlations greater than 0.8.

The Financial Accounting Standards Board’s definition of a bona fide hedge requires an R2 (percentage of variance explained) of 0.80 between instruments — which means the square-root of 0.80, or 0.894, is the number that must be exceeded. However, by applying this standard, only the EUR/DXY, CHF/DXY, and EUR/CHF pairs (highlighted in red) would qualify as bona fide hedges for one another.

Given the difficulty active currency traders have had in beating standard financial benchmarks over time, why should we believe they could properly select the currencies to hedge a multi-currency bond or stock portfolio? A few missteps by the manager and currency volatility could turn quite literally overnight a superior portfolio into an underperformer.