Emerging-market currencies have long forced investors to confront an uncomfortable question: how much return is enough to compensate for currency risk? Higher interest rates across emerging and developing economies are generally interpreted as compensation for weaker institutions, inflation uncertainty, capital-flow volatility and the possibility of sharp depreciation. Yet the historical record suggests that this compensation has frequently exceeded the losses investors ultimately experienced.

Recent research from ODI Global brings that discrepancy into focus. Across 34 low- and lower-middle-income currencies, the combination of local interest rates and exchange-rate movements has generated substantial cumulative excess returns relative to US funding costs. Since 2000, the aggregate index has risen from 100 to roughly 190. African currencies have performed even more strongly, with the regional index exceeding 220 despite repeated episodes of severe depreciation.

That is difficult to reconcile with a simple version of uncovered interest-rate parity, under which higher local interest rates should eventually be offset by currency depreciation. Instead, depreciation has frequently been too small to eliminate the interest-rate advantage. Even currencies experiencing dramatic losses, including the Ghanaian cedi and Zambian kwacha in recent years, have accumulated positive excess returns once their unusually high interest rates are incorporated.

The divergence is economically meaningful. The ODI data show that excess returns are not confined to a handful of successful emerging markets. Africa's cumulative return stands substantially above the aggregate index, while Asia-Pacific and Latin America and the Caribbean have also remained well above their starting values. The persistence of those returns raises the possibility that investors have demanded more compensation for currency risk than realized depreciation alone would justify.

But mispricing is only one possible explanation.

New IMF research offers an important counterpoint. A July 2026 working paper by Husnu Dalgic and Galip Kemal Ozhan finds that emerging-market currency premia can reflect structural exposure to bad economic states. In particular, dollar-denominated liabilities and the widespread use of dollars to price exports can make depreciation especially painful. When domestic currencies weaken, the local value of dollar debt rises immediately, damaging leveraged balance sheets. At the same time, if exports are priced in dollars, depreciation may provide less of the traditional boost to external demand.

That changes the interpretation of excess returns. Investors may not simply be overestimating the average amount by which a currency will depreciate. They may be demanding compensation because depreciation tends to arrive precisely when the marginal value of capital is highest: during recessions, tighter global funding conditions and periods of elevated risk aversion. The IMF finds that currencies more exposed to these global carry-trade risks earn higher average excess returns.

In other words, the average return may look unusually generous while obscuring the timing of the losses.

Hungary's experience provides a particularly useful real-time illustration. The forint has appreciated substantially against the euro since mid-2025. From around 400 forints per euro last July, the exchange rate moved toward 350 by mid-2026 before giving back some of those gains. For a foreign investor holding Hungarian local-currency assets, that appreciation magnified the already substantial income available from elevated domestic interest rates.

The currency move occurred alongside an extraordinary rally in Hungarian government debt. Hungary's 10-year government yield declined from more than 7% in mid-2025 to close to 5% by July 2026. Falling yields meant rising bond prices, while the stronger forint provided an additional currency gain for international investors. The result was a powerful combination of carry, duration and FX appreciation.

The trade became one of the standout emerging-market positions of 2026 before a global bond sell-off interrupted the rally. That reversal matters because it illustrates exactly why the premium cannot automatically be classified as an arbitrage opportunity. Emerging-market assets can produce exceptionally attractive returns while global liquidity is abundant and domestic fundamentals are improving, but those same positions can become highly correlated when global financial conditions deteriorate.

This leaves investors with a more nuanced conclusion. There is strong evidence that emerging and developing-country currencies have historically delivered returns exceeding the depreciation subsequently realized. ODI's data suggest that this is persistent, geographically broad and large enough to matter. Yet the IMF's research provides a mechanism explaining why at least some of that premium may be rational: currencies with dollarized financial structures can perform particularly badly during periods when investors themselves are least able or willing to absorb losses.

The central question, therefore, is not simply whether emerging-market currencies are risky. It is whether investors are being overpaid for bearing that risk.

Hungary's 2026 rally demonstrates the upside when high local rates, falling yields and currency appreciation align. The longer historical evidence suggests such outcomes are not isolated. But the persistence of excess returns can reflect both market inefficiency and compensation for concentrated tail risk.

For investors, that distinction is critical. If the premium primarily reflects exaggerated perceptions of average depreciation risk, emerging-market local-currency assets may remain structurally underpriced. If it primarily compensates investors for losses concentrated in global stress events, the excess return is less a free lunch than payment for providing insurance when the market needs it most. The evidence increasingly suggests that both forces may be operating simultaneously.

Sources & References

Financial Times. (2026). The red-hot emerging market trade being hit by global bond sell-off. https://www.ft.com/content/a883cdad-1851-46e1-a58f-ac5fedae2e3d?syn-25a6b1a6=1 

IMF. (2026). Dominant Currency Pricing and Currency Risk Premia. https://www.elibrary.imf.org/view/journals/001/2026/158/001.2026.issue-158-en.xml?cid=578314-com-dsp-crossref 

Odi Global. (2026). Excess returns in emerging and developing countries’ currencies: is currency risk mispriced? https://odi.org/en/insights/excess-returns-in-emerging-and-developing-countries-currencies-is-currency-risk-mispriced/