The Rand as a Source of Risk Premia

Vanessa Mabophe, Portfolio Analyst at Prescient Investment Management

Without robust risk management in place, the potential to harvest risk premia is to an investor what “hitting the jackpot” is to the frequent and hopeful lotto player.

With every dime invested, the prospects of delivering satisfactory outcomes become more likely whilst the downside risk gets heavily discounted. Though there may be a thrill from following this uninformed process, credible investment strategies rely on delivering long-term stable returns as opposed to ‘once in a lifetime’ jackpots. Furthermore, the best and most persistent way of harvesting risk premia and achieving long-term stable returns is ensuring that robust risk management is the bedrock of the investment process.

Risk premia, which is the compensation for taking on additional risk, can be derived from various sources. One of these sources is currency and the South African Rand has proven to be a good source. However, market participants are notoriously pessimistic on the Rand. This pessimism suggests that investors require greater compensation for taking on South Africa specific risks. One of the main driving forces of this rests on the fact that the Rand is a very volatile currency. The greater volatility implies that investors are exposed to greater risk, in terms of currency risk, when they bet their money on the Rand as opposed to other less volatile currencies. However, this added risk should not be taken as a sign to disregard exposure to the Rand. In fact, great value can be derived from the Rand, especially when proper risk management processes are in place.

Source: Bloomberg and Prescient Investment Management Research - 05 December 2019

In comparison to developed market economies, specifically the US, the Rand is attractive. Generally, the Rand should depreciate over the long term relative to the dollar, by the inflation differential - the difference between the prevailing inflation in SA and the prevailing inflation in the US.
However, the core determinant of risk premia when it comes to currency is the difference between the countries’ interest rate differential and the countries’ inflation differential. The wider the spread between the two, the better the compensation. Currently, there is a positive wider spread between the interest rate differential and the inflation rate differential (as depicted in figure 1 above). From a real value perspective, this suggests that one gets additional compensation for taking on local currency risk, i.e. investing in the Rand. Of course, the reliance on a systematic approach with a strong risk management overlay is necessary in translating the prevailing risk premia to long-term stable returns.