Tail risk hedging your portfolio using currency

In a recent paper[1] co-authored by staff from the Bank of England and the European Central Bank (ECB) on currency tail risk highlights how Australian investors can find the best ‘safe haven’ currencies whilst also identifying those that are ‘risky’.

The Australian dollar remains top of ranking in terms of an increased likelihood of a sharp depreciation (large downside entropy, in other words a measure of information), while at the opposite end of the spectrum there are a series of currencies with large upside entropies that behave as ‘safe havens’, notably the Swiss Franc, Japanese Yen and the USD.

Jamieson Coote Bonds (JCB) has long believed that one of the best negative correlation assets for AUD based investors is US denominated high grade fixed income. From top to bottom in the GFC, such a holding produced staggering returns for AUD based investors (positive ~70%) whilst risk assets melted around them (minus ~39%).

The ‘entropy’ of these assets is all important when building tail risk solutions, identifying in which direction they have historically slingshot under market stress. As seen in the chart below, in the face of tighter global financial conditions (market stress), the likelihood of observing a sharp appreciation (right tail) in the Swiss Franc, Yen and USD goes up significantly, while in the case of the Australian dollar it is the likelihood of a sharp depreciation (left tail) that goes up markedly.

A quantification of the sharp appreciation and depreciation risks