Sunday, 22nd October 2017
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John Smiles

Qualified Financial Advisor

What is

Currency Hedging?

Currency movements can have important effects on the return of unhedged foreign investments. For a Eurozone investor, currency returns are positive and increase the returns of unhedged foreign investments when the euro weakens. When the euro strengthens, currency returns are negative.

In 2014, the euro fell by about 7% against the pound sterling. This fall increased the returns of unhedged sterling-denominated investments held by Eurozone investors. Since June 2016, the pound sterling has fallen by 14% against the euro which has reduced the value of unhedged sterling-denominated investments held by Eurozone investors. Many investors, concerned by the impact of such currency movements on their investment returns, ask about the merits of hedging currency exposure within the international component of their portfolio.

Currency volatility is common and from 1974–2014, annualised currency returns, relative to a basket of developed markets currencies, had an annualised standard deviation of 7.47% and exceeded 10% in absolute value in 11 out of 41 years. Some investors may want to hedge currencies because they expect the euro to strengthen relative to other currencies. However, academic evidence suggests that currency movements are very difficult to predict in the short to medium term in a manner that is relevant for making investment decisions.

In global equities, hedging foreign currencies tends not to reduce return volatility by a significant amount. Equities are more volatile than currencies, so the volatility of an unhedged global equity portfolio is, on average, dominated by the volatility of the underlying equities, not the currency movements. As a result, unhedged and hedged equity portfolios have similar standard deviations.

Holding foreign equities and fixed income assets can offer important diversification benefits to investors. Predicting currency movements is very difficult. Therefore, investors should be cautious about making hedging decisions based on the recent performance of the British pound.

Hedging currency exposure is not an effective way to reduce equity volatility; the volatilities for unhedged and hedged equity portfolios have been similar.

For investment grade quality fixed income investments, investors seeking lower volatility should hedge their currency exposure because currency volatility composes a large portion of volatility in an unhedged portfolio.

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