Using multi-country multi-currency futures in portfolio management

• 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.

Over the last few years, regulatory challenges impacting the over-the-counter (OTC) derivatives market¹ have increased demands on exchange-traded derivatives (ETD) to deliver greater price transparency and offer access to deeper pools of secondary-market liquidity. As a result, the market for index-linked ETD products has grown substantially. Overall equity index-linked ETD volumes are up 23% in the first half of 2019 versus the first half of 2018.

But investors tell us that using a basket of single-country contracts provides only limited help in managing their equity exposures. Thus, we observe growing use of multi-country multi-currency futures. Regional, country, sector, factor or currency-hedged futures across developed and emerging markets can help investors target their exposure more precisely than proxies, as well as reduce operational risk. Moreover, the attractiveness of a single contract for exposure to a wide range of international markets offered in various currencies can be useful tools for transition management, overlays and cash equitization.

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:

1. Risk management: “How can I hedge my exposure to global IT equities?”
2. 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?”
3. Efficient market access: “How can I gain exposure to Saudi Arabia?”
4. Liquidity management: “How can I manage in- and outflows of funds? How can I raise capital while maintaining market exposure?”

In contrast to other forms of access such as using a proxy basket of local futures, multi-country multi-currency futures on indexes that match the investors' equity benchmarks have delivered more direct exposure with lower operational and tracking risks. Unlike swaps, futures are centrally cleared by the exchange and thus pose less counterparty risk. Finally, in comparison to ETFs, futures are unfunded instruments (besides collateral requirements) and hence provide a source of leverage and/or free up capital.

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.

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.

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.

Further Reading

The shrinking cost of currency hedging

Should you hedge your foreign currency exposure?

Does Turkey offer lessons for managing emerging-market currency volatility?