Using multi-country multi-currency futures in portfolio management
Blog post
September 3, 2019
- OTC total return swaps were one of the few synthetic instruments available for replication of regional or global benchmarks. Investors willing to bear benchmark risk could use a basket of futures and currency forwards instead.
- With the continued growth in exchange-traded derivatives supported by the need for increased price transparency and liquidity, investors have sought to efficiently integrate listed derivatives into their portfolios.
- Multi-country multi-currency futures are increasingly being used as a tool to manage market exposure, often as a cost-effective way to maintain exposures to target investment benchmarks.
Managing risk exposures
The globalization of equity portfolios has led to a greater focus on managing risk exposures. The returns of equity benchmarks, such as the MSCI World Index, are made up of two risk exposures: local equity-market risk and currency risk (from the non-base currency). Therefore, investors seeking to replicate benchmark performance must manage two sources of risk through synthetic replication instruments.
This gets tricky for a portfolio invested in multiple countries with various currencies. Investors seeking to replicate unhedged benchmark returns can use a basket of local futures for each country in the portfolio. But they also require a basket of non-base-currency forwards to gain the appropriate currency exposure. The currency basket would be designed to deliver 100% exposure to the underlying currencies of the benchmark, typically in proportion to the country weights.
In contrast, multi-country multi-currency futures on indexes such as the MSCI EAFE Index and MSCI Emerging Markets Index include both equity-market and currency exposure in a single instrument. These underlying indexes are unhedged and therefore contain the currency exposure of the underlying markets. In instances where the investors' base currency is not the same as the futures contract, an additional currency forward contract would be required to replicate the index (e.g., a EUR investor holding a USD-based futures contract would need a USD-EUR forward alongside the futures position).
How are multi-country multi-currency futures used in practice?
The substantial growth in futures we observe when examining listed futures linked to MSCI indexes is motivated by global investors seeking better portfolio-management tools that address these issues:
- Risk management: "How can I hedge my exposure to global IT equities?"
- Benchmark tracking: "How can I gain exposure to emerging markets without having to replicate the index using a basket of local futures, basket of currency forwards and/or stocks?"
- Efficient market access: "How can I gain exposure to Saudi Arabia?"
- Liquidity management: "How can I manage in- and outflows of funds? How can I raise capital while maintaining market exposure?"
Trends in the use of futures for exposure management
Aggregate volume of futures written on MSCI indexes across exchanges
Source: Based on data from MSCI, ICE Futures US, ICE Futures Europe, CBOE, Eurex, SGX, JSE, DGCX and HKEX
When we examine listed futures linked to MSCI indexes, we observe record volumes and open interest among exchanges globally. As of the end of June 2019, the total open interest in futures written on MSCI indexes across all exchanges amounted to USD 265 billion (largely, USD 123 billion for developed markets and USD 136 billion for emerging markets), which is nearly three times the level of only 2.5 years ago. Year-to-date (YTD) volume traded stands at USD 2.8 trillion (USD 956 billion for developed markets and USD 1.8 trillion for emerging markets).
Multi-country multi-currency exposures dominate MSCI futures volumes
The most popular multi-country multi-currency futures contract, in terms of value traded and open interest, is written on the MSCI Emerging Markets Index with over USD 1 trillion trading in 2019 YTD, an almost 14% increase on last year. Compared to other futures linked to MSCI indexes, Taiwan and Singapore are the only country indexes that feature in the top five futures contracts by value traded in 2019 YTD.
Top 5 futures | Value traded YTD (USD billions) | YoY change |
|---|---|---|
Top 5 futures Emerging markets | Value traded YTD (USD billions) 1086.43 | YoY change 13.7% |
Top 5 futures EAFE | Value traded YTD (USD billions) 531.61 | YoY change 18.0% |
Top 5 futures Taiwan | Value traded YTD (USD billions) 429.0 | YoY change 0.3% |
Top 5 futures Singapore Free | Value traded YTD (USD billions) 144.82 | YoY change -6.0% |
Top 5 futures EM Asia | Value traded YTD (USD billions) 125.74 | YoY change 40.5% |
Top 5 futures | Open interest (USD billions) | YoY change |
|---|---|---|
Top 5 futures Emerging markets | Open interest (USD billions) 75.64 | YoY change 16% |
Top 5 futures EAFE | Open interest (USD billions) 56.49 | YoY change 53% |
Top 5 futures Taiwan | Open interest (USD billions) 25.18 | YoY change 39% |
Top 5 futures Singapore Free | Open interest (USD billions) 20.44 | YoY change 39% |
Top 5 futures EM Asia | Open interest (USD billions) 13.41 | YoY change 42% |
Source: Based on data from MSCI, ICE Futures US, ICE Futures Europe, CBOE, Eurex, SGX, JSE, DGCX and HKEX
Investors are increasingly concerned about managing risk in their global, multi-currency portfolios. As they strive to construct more efficient portfolios, multi-country multi-currency futures markets are an option they can consider. We will look more closely at the use of multi-country multi-currency futures in forthcoming blog posts.
Further Reading
1For example, the European Market Infrastructure Regulation (EMIR) legislation enacted in 2013 aims to reduce systemic counterparty and operational risk and help prevent future financial system collapses.
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