Managing foreign currency risk
With investing portfolio assets internationally becoming more popular in recent decades, what factors are worth considering when deciding whether to hedge foreign exchange risk in portfolios?
- Foreign investment in equities globally increased almost six times between 2001 and 2020, as globalisation spurred international trade growth and international investing went mainstream
- Considering the impact of currencies on portfolio performance and risk is key when deciding whether to hedge currency exposure
- Currency hedging reduces the volatility of global government bonds much more than it does for global equities, making hedging government bonds but not equities a common choice
- The nature of the underlying currencies and the macroeconomic outlook can dynamically inform hedging decisions
- The lion’s share of the hedging cost is often down to the interest rate differential.
Global multi-asset class portfolios can provide exposure to growth, inflation, interest rates, credit, equities and commodities. In looking to add to returns, various risk premiums can be added by diversifying portfolios across asset classes and geographies. However, investors should carefully tailor their portfolios to strike the right balance of performance and risk, especially foreign exchange risk.
Potential risk from investing globally includes, depending on the hedging policy, adverse currency moves hitting portfolio performance. Additionally, taking exchange rate risk can limit “spending” the risk budget on sources of risk expected to be more rewarding. As such, appropriately managing this risk is crucial.
Asset allocation goes global
Globalisation spurred the growth of international trade from the early 1990s. In parallel, there was an unprecedented rate of financial innovation.
At the same time, international asset allocation as a form of investment went mainstream. The foreign investments in equities globally increased almost six times between 2001 and 2020 to $29.4 trillion, according to International Monetary Fund data. During the same period, there was a fourfold increase of foreign investments in debt securities to $31.9 trillion.
Furthermore, many countries have adopted a floating exchange rate regime since 1973, when the gold standard was removed. So it is little surprise that foreign exchange risk is generally a vital component for investors allocating assets internationally.
To hedge or not to hedge
When considering the impact of currencies on portfolio performance and risk, deciding whether to hedge the currency exposure is key.
Hedging currency exposure impacts fixed income investments – the volatility is substantially lower if global government bonds are hedged. By contrast, hedging global equities tends to be less effective and depends on the investor’s reference currency. For instance, hedging is usually preferable in US dollars and Swiss francs compared to euros and sterling.
The common practice is to fully hedge foreign fixed income investments and leave foreign equities unhedged. That said, it seems advisable to treat portfolio asset classes separately when making hedging decisions on portfolio currency exposure to efficiently allocate risk and meet risk budget constraints.
Plan strategically, act tactically
Foreign exchange markets are characterised by volatility outbursts and trends often driven by macroeconomic and political factors. Such events can generate additional hedging or speculative currency demand that can be met by crafting tactical currency overlay strategies.
In implementing currency hedging strategies, two questions are worth addressing. First, which factors are thought to explain exchange rate returns over short (tactical) and long-term (strategic) investment horizons? The answer depends on the nature of the underlying currencies (for instance, whether they are safe-haven or pro-cyclical ones) and macroeconomic prospects. Second, how much are any associated hedging cost?
Watch out for inflation differentials
The theory of relative purchasing power parity (PPP) seeks to explain moves in exchange rates solely as a reflection of differences in price levels in the respective currency areas. It can be useful to understand the relationship with the macroeconomic backdrop. Indeed, real (inflation-adjusted) exchange rates are much more stable over time than nominal exchange rates.
However, some currencies still show trend-like behaviour even in real terms (for example the yen and Swiss franc’s appreciation against the greenback in real terms since 1971). Some of these deviations can be explained by other economic fundamentals, such as accumulation of net foreign assets.
What cost hedging?
The lion’s share of the hedging cost is often down to the interest rate differential. For a euro investor hedging a US dollar equity position this was particularly expensive in 2018 due to the higher yield levels for the greenback needed to compensate dollar counterparties.
The price of hedging typically climbs as the demand to hedge goes up. Supply-demand imbalances are reflected in a second cost-factor: the cross-currency basis, which burst into life during the global financial crisis. The cross-currency basis can be substantial in periods of extreme stress. Meanwhile, bid-ask spreads for hedging transactions form a third cost-factor, which increases over time, especially for less liquid currencies.