Thinking in Terms of Foreign Exchange Adjusted Return for Risk Taken

Includes: IWM, MDY, SPY, VTI
by: Richard Shaw

In a recent article, we suggested that questions about the risk level or relative risk level of US Treasuries as measured by credit ratings shines a somewhat different light on the Sharpe Ratio. That is because the meaning of the "risk free rate" may be changing.

We wonder whether in a globalized economy, if it might also be useful to calculate a foreign exchange adjusted ratio of excess return achieved to volatility risk taken.

Perhaps something like dividing the excess return by the change in the U.S. Dollar index, or something like that might be useful.

Clearly, if U.S. markets were to provide nice excess return in Dollar terms, but the Dollar was depreciating in its global purchasing power, the return for risk relationship takes on a different meaning than if the Dollar is appreciating in its global purchasing power.

This table is a quick exercise showing the difference between 3-year total return in excess of 3-month Treasuries total return divided by 3-year standard deviation. One calculation is in U.S. Dollars, and the other adjusts the excess return for the 3-year annualized change in the U.S. Dollar index (based on a trade weighted basket of currencies).

(Click chart to enlarge)

The S&P 500 (proxy SPY) excess return was reduced from 2.64% to 1.65%, for example, when the purchasing power element was introduced. The excess return would have increased if the Dollar had increased in purchasing power.

Given that we buy materials and goods globally, it may be useful to think more in terms of exchange rate adjusted results than merely Dollar results.

It's obvious when you say or hear it, but few results reports are expressed or discussed in such adjusted terms.

Disclosure: We hold SPY and IWM in some but not all managed accounts as of the publication date of this article.

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