Effect of exchange rate volatility on returns of investment portfolios in South Africa

Abstract

The movement of globalisation has undoubtedly shaped the modern world of today. Investors have countless options available to them in their investment endeavours, including exploiting investment opportunities in foreign economies. Although international diversification of investment portfolios creates substantial financial gains opportunities, exchange rate risk can play a prominent role when investing in international markets. It is therefore essential to establish what the effect of exchange rate volatility is on investment portfolios. Numerous studies have identified that there exists a relationship between exchange rates and investments. However, there seems to be no clear consensus on this relationship as a variety of studies produce mixed findings. One clear finding is that this relationship is largely dependent on the country, as each country is exposed to different shocks due to differing policies, political structures, and exposure to the international market and largely due to the exchange rate structure employed in the country. This study examines how the exchange rate fluctuations influence South African investment portfolios. The empirical objectives are to establish whether exchange rate volatility influences portfolio prices of domestic-based investments relatively to portfolio prices of international diversified investment and to determine whether investment portfolios can be used to diversify exchange rate risk in the South African context. An autoregressive distributed lag (ARDL) model with a causality analysis is used to analyse 125 monthly observations from April 2006 until August 2016. It is found that, in the majority of the cases, the exchange rate fluctuations have no long-run relationship with the investment portfolios. However, a few instances were identified where a long-run relationship exists. A uni-directional relationship from investment portfolio to exchange rate was noted, in most of the cases. The short-run analysis indicates that domestically diversified investment portfolios are influenced by the exchange rate through a lagged effect. Conversely, international investment portfolios tend to be influenced by the current exchange rates rather than by the lags of the exchange rate. An interesting finding was that domestically diversified investment portfolios tend to weaken as the South African rand depreciates in the short-run. Conversely, internationally diversified investment portfolios tend to strengthen in response to a depreciation of the South African rand in the short-run. It was thus concluded that exchange rate risk can be diversifiable in the South African context. Effect of exchange rate volatility on returns of investment portfolios in South Africa.