Investments in overseas instruments such as stocks and bonds can generate substantial returns and provide a greater degree of portfolio diversification, but they introduce an added risk, that of exchange rates. Currency management plays an important part in portfolio management, particularly as investors access a greater range of international investments. Hedging can help to lower risk in a portfolio and the decision to hedge or not to hedge is often dependent on the characteristics of the asset class being invested in and the risk and return objectives of the particular fund.
When purchasing units in an unhedged fund that invests overseas, an investor is effectively holding overseas assets in the foreign currency. As a result, the value of these assets in may be affected by changes in the value of the investor’s native currency relative to the value of the foreign currency. Since foreign exchange rates can have a significant impact on portfolio returns, investors should consider hedging this risk where appropriate. From an investor’s perspective, currency hedging enables the value of offshore investments to be protected from changes to the exchange rate.
Fund managers seeking to manage their currency exposures can pursue one or more strategies: trade over-the-counter (OTC) market currency forwards and options, exchange-traded futures and options on futures, or hire the services of an overlay manager. Overlay managers are essentially specialist currency trading firms that will actively manage a currency hedge mandate, and in addition, attempt to generate a positive excess return. These firms too rely on currency futures, forwards and options contracts.
For example, if the Australian Dollar declines against the U.S. Dollar (and asset prices remain unchanged), a U.S. Dollar asset rises in value in Australian Dollar terms. Conversely, if the Australian Dollar strengthens (and asset prices remain unchanged), the investment falls in value.
There are essentially two kinds of risk investors may mitigate with hedging:
Income or Transaction Risk. Transaction risk is the risk that arises when a receipt or payment is due in a foreign currency but the end payment is received in Australian Dollars. The risk is that by the time the investor receives the payment, the income generated offshore will be reduced when it is converted back into Australian Dollars if there is a rise in the Australian Dollar exchange rate.
Capital Value Risk. For an Australian investor, there is the risk that the capital value of the investment will fluctuate as a result of movements in the exchange rate, as the value of foreign currency is converted into Australian Dollars. For example, if an Australian-based investor holds a U.S. Dollar investment and if the value of the Australian Dollar rises relative to the U.S. Dollar then, when measured in Australian Dollar terms, their U.S. Dollar investment is now worth less than before.
How does currency hedging work?
Generally speaking, there are two types of currency management strategy, value-adding and protection. Value adding (or active) strategies use currency hedging to enhance returns. Protection strategies, such as passive hedging, use currency hedging to reduce the risk of currency exposure.
Managers may choose to fully hedge currency exposure, removing any impact from currency fluctuations or partially hedge in order to achieve a result somewhere between that of a fully hedged portfolio and an unhedged portfolio.
When hedging, performance is translated into an Australian Dollar cash environment. For example a U.S. Dollar 6% return (made up of 1% cash rate + 5% outperformance) would be translated into an Australian Dollar return of 11%, (the Australian Dollar cash rate of 6% + 5% outperformance).
Hedging, from an Australian perspective, tends to produce a positive return for Australian investors because overseas cash rates are often lower. For instance, the U.S. cash rate is currently 0.25%, the U.K.’s is 0.5%, the European Central Bank’s is 1.25% and Japan’s is 0%.
Steps to Hedge Currency
1. Purchase forward contracts. A forward contract is a contract that requires you to sell or buy a set amount of currency at a fixed rate at some specific date or time period in the future.
– Forward currency contracts are especially useful and popular among businesses and individuals who pay or receive payment in a foreign currency at some point in the future.
– By making a forward contract for the same day your business will make a payment in a foreign currency, you can determine, in advance, exactly how much the payment will cost you today in your native currency.
2. Buy foreign currency options. Foreign currency options give the purchaser the option to sell or buy a foreign currency contract at a specific price on a specific date.
– When the specific date (known as the expiration date) of the contract arrives, the buyer of the contract can exercise the option at the agreed price (known as the strike price), if currency fluctuations have made it profitable for them. If fluctuations have made the option worthless, it expires without the company exercising it.
3. Arrange foreign currency swaps. Much as it sounds, a foreign currency swap is an agreement in which two parties agree to swap equal amounts of two different currencies at the spot foreign currency rate.
– The seller and buyer then exchange interest payments in their swapped denominations over the term of the contract. At the end of the contract, the parties trade back the initial amount at an agreed upon exchange rate.
4. Buy gold
– You can use gold and other precious metals to hedge currency positions. Investors have used gold as a hedge since ancient times, and many investors still keep gold in their portfolios to guard against economic pitfalls or disasters.
5. Exchange some of your native currency for a foreign currency.
– One of the simplest ways to hedge your currency holdings is to buy some foreign currencies. If you live in a country that uses the Euro, for example, you can buy U.S. dollars, Swiss francs or Japanese yen. If the value of the Euro drops relative to the other currencies, you have sheltered yourself to the extent that you’ve purchased other currencies.
6. Buy spot contracts. A spot contract is an agreement to sell or buy foreign currency at the current rate and requires execution within two days.
What are the risks of currency hedging?
While currency hedging may enhance investment returns, there are a number of risks that an investor should consider. There is the risk that the valuations for the hedging instrument may not accurately reflect the valuations for the physical securities on which it is based, due to timing or pricing variations.
The volatile nature of foreign exchange markets may mean that the losses (or gains) on a foreign exchange hedge vary from the foreign exchange related gains (or losses) on the underlying physical securities.
