There have been two significant bouts of volatility in emerging currency markets since May last year, each featuring large losses on “carry trades” which involve borrowing low-yielding currencies to invest in higher-yielding ones.
Volatility among emerging currencies is low at the moment and close to the lows of the past decade. Global financial market stress as measured by indicators such as the VIX is also low. But this does not mean that investing in emerging currencies is necessarily low risk. As noted, crash risk is ever-present and can materialise suddenly as a result of various triggers.
With US tapering ongoing and emerging countries still beset by imbalances and structural problems, there is a risk of further sell-offs in emerging currencies ahead.
Using five indicators, we compiled a combined FX risk score. Comparing this with existing carry levels allows us to conduct a quick risk/reward analysis as a useful starting point for potential investment decisions.
Such an analysis suggests that the riskiest currencies are the South African rand, Brazilian real and Turkish lira. The Thai baht also looks unattractive with relatively high risk and low returns. Cautiousinvestors might prefer markets such as South Korea, the Philippines and Mexico, with Indonesia perhaps the least risky of the high-yielding currencies.
The writer is senior economist at Oxford Economics.
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