Over the last two decades the deregulation, growth and integration of the world financial markets, combined with significant changes in the politics and economic climate around the globe, have resulted in a tremendous increase in international investments. In a 1994 survey, the top 1000 US pension funds reported that total international investments had increased by 32% in the last year, from $126.89 billion to $167.44 billion (Price, 1995). Furthermore, these investments are projected to grow further with experts predicting world pension assets will increase by 59.3% to $11.2 trillion by 1999.
The level of international investment, however, varies significantly across countries. For example, in 1993 4.5% of US pension fund assets were invested in international equities (Bajtelsmit and Worzala, 1995) while UK pension funds reported 25% of their funds were invested overseas (Sweeney, 1993).
Over the last 30 years there has been a significant amount of research indicating that international investing does provide diversification benefits with respect to reduced portfolio risk and enhanced portfolio performance for stocks and bonds (see Grubel, 1968; Solnik, 1974b; Jorion, 1985; Odier and Solnik, 1993; and Solnik, 1994). However, only in the last few years have researchers explored the diversification benefits associated with including international real estate investments within a mixed-asset portfolio.
Similarly, a significant amount of research has been done on the general financial decision-making process and criteria for real estate investments (for example, see Hudson-Wilson and Wurtzebach, 1993). However, there has been very limited research concerning international real estate investment and financial strategies or the real estate finance decision-making processes used to make these alternative investment decisions.
Up to now, the perceived risks associated with real estate investments in a foreign market-including political and economic risks and a lack of understanding of the international real estate market-have discouraged institutional investors and tended to offset any diversification benefits.
The major factors which are now contributing to an increased interest in international real estate include: favourable exchange rates, lack of local opportunities, interest rate differentials, greater liquidity of international real estate markets, political diversification, economic diversification, arbitraging market conditions, perceived comparative advantages, substantial growth in available investment funds, investment stability, improved global communication, improved market information, and access to investment capital (Newell and Worzala, 1995; and Baum and Wurtzebach, 1993).
As institutional investors begin to get a better understanding of the available investment opportunities, it is likely that this interest will continue to grow.
Inevitably, as international direct and indirect property investment has become more significant, attention has turned to the impact of exchange rate movements on the returns received from foreign real estate. While property market returns may be superior overseas, the returns may be eroded by adverse currency movement. Alternatively, below average real estate returns may be transformed if the foreign currency appreciates against the domestic currency.
Japanese investment in the United States provides an example. In the 1980s, poor commercial property performance was compounded by appreciation of the yen against the dollar. More recently, however, recovery in US property markets has been accompanied by yen depreciation. Timing of investment is thus critical. Sterling appreciation against North American, European and Far Eastern currencies in the mid-1990s would have damaged foreign investment returns; however, it might be profitable to acquire while the pound is strong.
The aims of this paper are to review research on currency risk and international property investment, to examine market practice and to assess available currency hedging strategies. The paper begins with a review of the literature on international property investment and exchange rate risk. It examines three related issues: the possibility of hedging currency risk, the influence of currency on the investment decision and the importance of economic and financial convergence. Next, section three reports on the findings of a series of interviews conducted with international property investors and advisors.
These interviews examined motivations for 'going global', the decision-making process and the ways in which currency considerations influenced behaviour. The semi-structured interviews were carried out in 1996 and early 1997, mainly in New York and London. Section four considers currency hedging explicitly, by examining the feasibility of hedging currency risk using a currency swap vehicle. The impact of using a swap to manage currency risk is tested using Monte Carlo simulation for a realistic set of property and exchange rate scenarios.
Home » Unlabelled » Currency swaps for hedging a realistic international real estate investment: do they work?
