Whenever you invest in foreign equity, you are also making an implicit investment in a foreign currency as well.
Currency hedging is a financial strategy to mitigate the risks of fluctuations in currency or foreign exchange rates. It seeks to reduce exposure to foreign exchange risk while retaining the original equity exposure.
CURRENCY CAN BE DIFFICULT TO PREDICT:
Currency trends may move in waves, significantly impacting investments over time. Predicting these fluctuations is quite challenging, especially in the short term since currencies can vary significantly.
As international trade and investments become more common, the value of currencies is more likely to have an impact on the financial health of investors and companies under the large and unpredictable effects on returns on foreign equities.
Currency hedging serves as a protective shield, shielding these stakeholders from potential losses caused by adverse currency movements.
Investors who want to reduce or eliminate this risk of foreign currency exposure in their portfolios may consider a currency hedging strategy.
WHY HEDGE CURRENCIES?
Imagine you are an investor based in Canada, who invested CAD 1 million in a European stock index fund. At the time of your investment, the CAD and EUR were equal in value, as the exchange rate was 1 CAD to 1 EUR, and the European stock index is valued at 1 million EUR.
After your investment, the European stock market gains value, and your investment grows by 30%, resulting in a portfolio value of 1.3 million EUR. However, during the same period, the Euro depreciated against the Canadian Dollars causing the exchange rate to shift from 1 CAD to 0.70 EUR.
• Without currency hedging:
Your portfolio, when converted back to CAD, is now worth CAD 910.000 (1.3 million EUR * 0.70 CAD/EUR).
• With currency hedging:
However, if you had employed a currency hedging strategy to lock in the initial exchange rate of 1 CAD to 1 EUR, your portfolio would still be worth CAD 1.3 million (1.3 million EUR * 1 CAD/EUR).
In this scenario, using a currency hedging strategy has preserved the full value of your investment in CAD, while not using currency hedging resulted in a loss of CAD 90,000 due to the exchange rates.
This example illustrates that currency can be hard to predict and without currency hedging, it may lead to significant effects on your portfolio’s return.
Currency moves in waves and therefore can have a significant effect on your profit or investments over certain periods. In the short-term predicting which way, it will go is particularly challenging. Currency hedging is a risk management tool that plays a significant part in mitigating or avoiding this loss and can help protect the value of your international investments and provide greater stability in your portfolio returns.
HOW CURRENCY HEDGING WORKS?
Here are the excellent strategies for hedging your portfolio against currency volatility:
Forward Contracts
Using a forward contract is one of the best ways to mitigate the impacts of foreign exchange risk.
A forward contract is a customized agreement between two individuals to buy or sell a specified amount of currency at a predetermined exchange rate at a future date. This allows us to reduce exposure to currency fluctuations.
CDF
A Contract for Difference (CFD) is a derivative for hedging foreign exchange risk. Traders don't need to own the underlying currency. With a CFD, they exchange the price difference of the currency from position open to close. Profit occurs if the market moves as predicted, with potential losses if it moves against. CFDs offer a flexible way to manage currency risk without owning the currency.
ETFs
Currency-hedged ETFs are simple, cheap, and effective way for small investors to access currency management techniques. The ETF issuer typically does this by entering forward foreign exchange contracts (or similar instruments) with a third party, enabling the buyer to set an exchange rate at a certain price for a certain period.
This means that when there is a loss in the value of the underlying ETF holdings that is attributable to currency movements, the forward contract is expected to provide an offsetting gain, and vice versa.
CURRENCY OPTIONS
Currency options provide the holder with the right, but not the obligation, to buy or sell a set amount of currency at a predetermined exchange rate during a specified period. Offering more flexibility than forward contracts, currency options also entail higher costs.
NATURAL HEDGING
Natural currency hedging involves managing currency risk without relying on financial derivatives. An example is a holding company with subsidiaries aiming to balance foreign currency receivables and payables, providing an inherent hedge against currency fluctuations. Natural hedging is much less precise than hedging with forward contracts.
Currency Hedging: Advantages and Disadvantages
There are the various pros of currency hedging strategy: by mitigating exposure to fluctuations in exchange rates, currency hedging can significantly assist businesses and investors. Most investors are more concerned about losses resulting from adverse currency movements rather than gains derived from favorable one. Currency hedging enables investors to withstand challenging market conditions and substantially reduces losses. Minimizing or averting losses due to fluctuations in exchange rates is achievable.
This can help businesses confine their exposure to unexpected currency movements and curtail the potential impacts of currency rate fluctuations.
Currency hedging provides an opportunity to lock in favorable currency movements. Sudden and rapid increases in exchange rates can detrimentally impact on companies’ payment performance. This is particularly pertinent for companies that have foreign currency-denominated debt and import goods with foreign currency. Exchange rate increases disrupt their cash flows and escalate their costs. Companies engaged in exports within a specific country, through currency risk mitigation, shield themselves from the adverse effects of exchange rate fluctuations. Consequently, managing financial risks and averting substantial losses in adverse currency movements becomes more feasible.
In certain instances, maintaining an unhedged currency exposure can yield diversification advantages, particularly when there exists a historical negative correlation, often referred to as negative equity-FX correlation, between a country’s equities and its currency movements. In such circumstances, the interplay between these two assets can offer potential diversification.
In summary, investors venturing into international markets should conscientiously assess the implications of currency fluctuations within the international segment of their investment portfolios encompassing both equities and bonds. The proliferation of currency-hedged-Exchange-Traded-Funds (ETFs) has equipped investors with the tools required to articulate their perspectives on this matter.
Currency hedging can provide stability and predictability for businesses engaged in multiple currencies. This reduces the impact of exchange rate fluctuations on financial statements and cash flows. Currency hedging can enhance financial stability for businesses, potentially influencing credit ratings and favorable financing terms. Additionally, it supports stabilizing cash flows, a critical aspect for companies as it ensures that currency fluctuations do not disturb their financial stability or their ability to meet financial obligations. Moreover, currency hedging fosters greater stability and predictability in future financial planning and budgeting, enabling businesses to engage in more effective strategic planning. A successful hedging operation provides protection to investors against fluctuations in commodity prices, exchange rates, interest rate, inflation and more.
Fluctuations in exchange rates can impact on businesses’ costs. Hedging against currency risk can encourage better costs and potentially enhance profit margins. It also enables the adoption of a more flexible pricing strategy, as it requires less margin expenditure. Currency hedging operations need not necessarily be costly in terms of transaction expenses. Currency forward contracts are highly liquid and offer a relatively cost-effective means of hedging. Such operations typically do not incur high fees. Furthermore, it enhances liquidity by allowing investors to diversify their investments across various asset classes, contributing to increased liquidity in financial markets.
A 'Defined Benefit Pension Fund' is a retirement plan in which employers commit to providing retirees with a predetermined sum upon retirement. These funds typically include a mix of assets across various classes, sometimes involving foreign investments, which exposes them to currency exchange rate fluctuations. When a business or pension fund commits to making future retirement payments in a specific currency, they face the risk associated with currency fluctuations. These fluctuations can impact the value and amount of retirement payments, especially when pension benefits or other retirement funds are tied to a foreign currency. To address this challenge, businesses and pension funds employ currency hedge transactions as a risk management strategy. Currency hedges help reduce the adverse effects of exchange rate fluctuations, providing a level of protection for retirement payments.
On the other hand, while currency hedging is a valuable strategy for risk protection, it comes with its own set of risks. Some potential cons of hedging include:
Currency hedging against foreign exchange risk can result in additional costs for businesses. When using derivative products such as forwards, swaps or options, companies are obligated to pay premiums or commissions for these contracts. Some derivative products may also necessitate margin or collateral from a company’s accounts, potentially constraining its cash flow and leading to liquidity issues. Additionally, when businesses make payments for the derivate products used to currency hedge against foreign exchange risk, they may need to calculate interest on these payments, which becomes a significant factor, particularly for long-term foreign exchange risk hedging transactions. The execution of foreign exchange risk hedging transactions is typically conducted through banks and financial institutions, incurring transaction fees. These costs have the potential to impact on a company.
Hedging can limit potential gains from favorable currency movements in the exchange rate depending on the hedge ratio used and may result in missed investment opportunities. When a business engages in transactions involving a foreign currency, any positive fluctuations in that currency ‘s value can be advantageous for the business. The business a convert its foreign income at a higher exchange rate and potentially earn more from the local currency if there is no currency risk hedging in place.
Foreign exchange rate movements depend on various factors. Incorrect predictions can lead to adverse outcomes. Exchange rate fluctuations are susceptible to unforeseen surprises. Wrong forecasts may result in unnecessary currency hedging, incurring additional costs, and potentially diminishing the profitability but also causes missed opportunities to benefit from favorable fluctuations. Disadvantages of currency hedging against foreign exchange risk, emphasizing the potential negative impacts of incorrect forecasts and the associated costs as well as the missed opportunities for profit when employing risk mitigation strategies.
When allocating the capital and resources required to hedge against foreign exchange risk, a business should consider its future cash flow requirements and operational flexibility. Setting aside capital for hedging foreign exchange risk implies that it cannot be utilized for other potential projects or urgent liquidity needs. Simultaneously, while using financial derivative products- they may leverage their credit limits, which in turn offers less flexibility in meeting financing needs and leads to cash flow issues.
Currency Hedging Strategies Impact on Equity and Bond Performance
A study by Credit Swisse shows how currency hedging works, and if it is a good strategy to optimize a portfolio.
Obviously, investors enjoy gains from investments in countries whose currencies appreciate and suffer losses when currencies depreciate. So, they often argue that it is better to invest in countries with strong currencies. This theory is true only if we can successfully predict which currencies will be strong in the future, and that’ s not an easy prediction.
The first thing to do is understand if past currency movements are related to the future returns on equities and bonds. In other words: is it better to invest after periods of currency strength or weakness?
In their studies, the Credit Swisse analysts used the Dimson-Marsh-Staunton (DMS) database of 19 countries since 1900, implemented by other 64 countries, mostly emerging markets.
In several parts of this paper, they have divided their analyzes into two historical periods:
- The first period is the one that goes from 1900 to 1971.
- The second period is called “post-Bretton Woods era” and goes from 1972-2011.
This distinction is important, because since 1972 exchange rates exchange rates have become floating, and this has a significant impact on currency hedging.
Each New Year, they rank countries by their ex- change-rate change over the preceding 15 years and assign them to one of five quintiles from the weakest currency to the strongest.
Then they invest on an equal-weighted basis in the markets of each quintile, reinvesting all proceeds including income.
Figure below shows them results:
As we can see, equities performed best after currency weakness.
For bonds, the graphics are less clear. The group of bars in the right, shows that after Bretton Wood period, therefore under a regime of floating exchange rates, bonds, like equities, perform best after period of currency weakness, although the relationship is weaker than for equities, while is not apparent over the full 1900-2011 period.
So, except in the first half of the 20th century, both equities and bonds performed best after currency weakness. The reason for this lies in volatility, which was higher in the weakest currency quintiles. However, even a performance risk-adjusted ratio, like the Sharpe ratio, confirms clear outperformance after currency weakness.
Even if their analysis ignores some aspects like dealing costs, taxes, or risk adjustment, it provides some support for those who favor “buy on weakness” strategies.
Now, the next question is “should we hedge exchange rate risk”?
Today, with floating exchange rates and liquid forex markets, it is unlikely that currencies can deviate from fair value for long periods of time. However, shorter-term deviations can be large which entails currencies volatile. So, by how much does currency amplify the risks of foreign investments?
As we know (and as we can see in the two following tables), investing in global equities, rather than just domestically, reduces portfolio volatility. In fact, the standard deviation of annual returns on the world index is much lower than the average standard deviation of individual markets.
A US investor can follow two different strategies:
1) He can invest dividing his assets equally between the 19 markets, of which one is the US.
2) He can invest all his money in the weighted world equity index (based on our 19 countries).
The results of these two strategies are showed in the Table below
The currency hedge reduce volatility by only 0.7% because much of the world’ stock market risk is already diversified.
In the second part of Table 1, are shown the results of the same analysis but now for a US based bond investor. As we can see the hedge reduces volatility but 15.9% to 9.9%, so the hedge has a big impact on volatility for a bond investor.
Now let’s take the point of view of any non-US investors of our study (18 investors).
As a summary, table 2 presents the average of all 19 countries.
While the volatility of a hedged portfolio is lower than an unhedged portfolio, as in the US investor case, the annualized returns on the unhedged and hedged strategies are virtually identical. In fact, in a currency hedge, one party’s profit is a counterparty’s loss. Consequently, on average across all parties, hedging makes essentially no difference to investment returns.
The most important difference between these two tables is that in the second case the unhedged investor has underperformed the hedged strategy by 0.7%. The reduction in return from hedging in Table 1 has become a profit in Table 2. That is a consequence of the end of Bretton Woods period: investors who are concerned with the purchasing power of their investments on average benefitted from avoiding US dollar exposure.
Studying the same pattern of countries on a 112-years perspective, Credit Swisse claims that while currency risk is mitigated by its low correlation with real asset returns, it still adds to overall risk, with a higher proportionate increase for bonds than equities.
Hedging can reduce, but cannot eliminate, risk due to the uncertainty of future returns, and we therefore don’t know in advance what quantum to hedge.
Usually, the investor strategy involves hedging the initial capital over the period until the hedge is rebalanced.
The benefits of hedging fall longer the horizon of an investment, and rapidly turn negative. Rather than lowering risk, hedging by longer term investors raises risk, with the only exception for the world equity index in the post Bretton Woods period.
These results arise from the high US and Japanese weightings.
Predicting currencies is difficult, and the economics models of exchange rates fail to predict, and Kenneth Rogoff studies demonstrate it (“Explaining the yen, dollar or euro… is still a very difficult task, even ex post” Rogoff, 2002).
But after adjusting for style factors, there is little evidence that currency managers generate exceptional performance, as Richard Levich shows in his works (2008).
The currency-style factors are themselves of interest as they imply some level of predictability.
Although currencies generally tend to move towards purchasing power parity (PPP) over the long term, this trend is of limited value for short-term forecasting. On the other hand, carry trades have demonstrated profitability and may be included as part of the arsenal for those engaging in dynamic hedging strategies.
It’s important to note that even if investors can anticipate currency fluctuations, adjusting asset allocations towards countries expected to possess strong currencies and away from those anticipated to weaken is not the most effective approach to capitalize on this insight. Instead, direct engagement in the currency markets is more advisable. Employing a currency overlay allows the desired distribution across assets and countries to remain unchanged.
Conclusion
When evaluating the decision of hedging foreign currency exposure, investors need to consider several factors:
· Outlook on Prospective Returns
· Currency Exposure in Portfolio
· Expected Correlation Between Foreign Assets and Currency Returns
· Cost of Hedging
Once the decision to hedge is made, determining the optimal extent of hedging is the next strategic step. While conventional approaches often involve a 50% or full hedge, the best approach is to consider risk-return trade-offs and accommodates various objectives and constraints, including expected return, volatility, tracking error, costs, and liquidity of portfolio.
Strategic currency hedging decisions can provide risk reduction and slight risk-adjusted return improvements, this comes with the trade-off of added hedging costs and operational complexity, both for managing the hedges and for establishing hedging policies.
The challenges, costs, and research involved weigh against currency hedging, particularly for a private investor. In a 2016 essay titled "Long-Term Asset Returns," Dimson, Marsh, and Staunton demonstrated that between 1900 and 2015, global real exchange rates were quite volatile but did not appear to exhibit a long-term upward or downward trend. In other words, over the past 115 years, currencies experienced significant fluctuations in relative value, but exposure to one currency over another would not have been superior.
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