Risk ManagementMar 31, 20265 Min

How do Global Portfolio Investors Hedge Currency Risk?

The key benefit of investing in global stocks is that it offers you investing and diversification opportunities beyond the local market. The key downside, however, is that these stocks involve currency risk that can either significantly boost investment returns or weaken them. The US dollar holds more significance as it is involved in over 89% of $9.6 trillion per day global FX trading. Figures are indicative and may vary over time.

In this blog, we will understand what currency risk and forex hedging are, and how investors may hedge the risk.

What is Currency Risk?

Currency risk is the chance that exchange-rate changes can change the value of your foreign investments. Investing in global stocks involves swapping home currency for the foreign currency. For example, if an investor is investing in US stocks from India, they would swap Indian rupees for US dollars.

When an investor sells shares after the exchange rate has changed, the exchange rate on the settlement date determines the final amount in the home currency, acting as a multiplier on investment gains or losses. Currency risk occurs only in international investments in equities and bonds. For example:

• Equities: By holding a US stock as an Indian investor, you are exposed to the performance of the stock as well as the USD/INR exchange rate. A weakening USD will cut your gain in INR terms even when the stock increases by 10%. This example is for illustrative purposes only.
• Bonds: A foreign government bond has interest in its local currency. When such currency depreciates, the interest and principal that will be translated back to your home currency will be less. Bond investments are also subject to credit and interest rate risk.

Currency risk is different from market risk and inflation risk. Changes in exchange rates mainly impose currency risk. Market risk is when the value of assets like stocks and bonds falls because of market movements. In contrast, inflation risk is the risk of increasing prices undermining the purchasing power, irrespective of the returns on investments.

How Movements Affect Currency Risk in Portfolio Returns

Here are the two key factors that determine the overall performance of your portfolio when investing in the stock market:

• Local asset performance: The performance of the investment in its local market, in its local currency.
• Currency effect: The effect of exchange rate fluctuations on the value of that investment when converted back to your home currency.

For example, US stocks can increase by 10% in USD, but when the USD declines against the domestic currency, the overall return in domestic currency terms may be lower than expected. On the other hand, the stock may decline by 5% in local currency, but a strong foreign currency can cover up the loss or generate a slight gain when translated. These scenarios are hypothetical and do not reflect actual market performance.

The most important thing is that currency impact may be either positive or negative, and it is hard to predict. This allows it a significant consideration in the construction and management of global portfolios, particularly to investors who desire long-term, consistent returns. There is no guarantee that any strategy will achieve its intended outcome.

Currency Risk in Global Equity Portfolios

Equities are known to have growth potential and volatility risk. The prices vary depending on the performance of the company, industry trends, and the general market conditions. Currency exposure introduces an additional uncertainty on top of these market movements when investing internationally.

Even good-performing foreign stocks can give lower or higher returns based on the movement of the foreign currency against your home currency. The currencies of developed markets such as USD, EUR, and JPY are more stable, yet even minor changes can have a huge effect on large portfolios. The emerging market currencies tend to be more volatile, and this may increase the gains and losses.

• An American investor holding Japanese stocks is exposed to the JPY/USD changes.
• A currency fluctuation for an Indian investor in emerging market equities can be much greater than that experienced in the developed markets.

These regional differences are important for global investors to understand. Currency risk allows you to estimate the possible fluctuations in returns and make a more informed decision regarding currency hedging or diversification. Investors should assess suitability based on their individual objectives and risk tolerance.

What is Currency Hedging?

Currency hedging is a strategy that global investors use to eliminate or minimize the effects of exchange rates on their foreign investments. It protects your portfolio against losses that can arise in case of a weakening of a foreign currency against your home currency.

Hedging does not remove market risk, but helps you manage risk. Your investment is still subjected to an increase or decrease depending on the performance of the underlying assets. Hedging aims to offer more predictable portfolio performance by reducing currency-based volatility. Hedging strategies involve costs and risks and may not be suitable for all investors.

Common Strategies Global Investors Use for Currency Hedging

Here are the strategies that global investors use for forex hedging and protecting their investment:

1. Currency-Hedged Funds and ETFs

Many mutual funds and ETFs offer currency-hedged versions. These funds automatically hedge the impact of currency changes with the help of financial instruments. Your returns will primarily reflect the performance of the underlying assets rather than exchange-rate movements. Such products may be suitable for investors seeking to reduce currency-related volatility, subject to their individual circumstances.

2. Forward Contracts and Futures

Currency futures and forward contracts are contracts that are used to purchase or sell a foreign currency at a specified rate on a set date. These instruments fix the exchange rates and hedge against unfavorable currency fluctuations.

Although they are very effective, they are mostly applied by institutional or sophisticated investors because they are complex and may be expensive. For retail investors, these are usually implemented indirectly through funds or ETFs. Derivatives carry additional risks, including leverage risk, and may result in losses exceeding the initial investment in certain cases.

3. Global Diversification as a Natural Hedging

Another effective way of hedging currency risk is by diversifying the portfolio across multiple countries, currencies, and asset classes. The fact that your portfolio is exposed to multiple currencies implies that losses incurred in one currency can be compensated by gains in another. This strategy does not remove currency risk but minimizes portfolio volatility without the use of extra financial instruments.

4. Asset Allocation Choices

Here are the different types of assets that are more or less susceptible to currency fluctuations:

• Bonds vs equities: Foreign bonds can be more exposed to currency, whereas equities (stocks) can have some natural hedges in case the company has multiple currency sources of revenue.
• Geographic allocation: Investment in both developed and emerging markets will diversify the currency risk and reduce the reliance on one currency. Diversification does not eliminate risk of loss.

Hedged vs Unhedged Portfolios: Major Trade-offs in Currency Hedging

Here are the trade-offs between hedged and unhedged portfolios you must be aware of when hedging currency risk:

1. Low Volatility vs Potential Return Drag

Hedging can smooth the portfolio returns by protecting against unfavorable currency fluctuations. This protection, however, comes at a price: in case the foreign currency appreciates, a hedged portfolio will miss out on the extra gains. It will be a possible drag on returns relative to an unhedged portfolio.

2. Cost of Hedging

Currency hedging is associated with transaction costs, fund management fees on hedged ETFs or mutual funds, and occasionally financing costs of derivatives. These expenses can cause a minor decrease in the returns of the whole portfolio. This is why it is necessary to balance the advantage of risk reduction with costs.

3. Short vs Long-term Investment Horizons

The hedging is mostly useful in the short- to medium-term horizons, where the currency swings can have a substantial impact on the returns. To long-term equity investors, the impact of currency fluctuations is usually leveled out in the long run. Remaining unhedged can allow the investor to realize possible currency gains.

When Does Currency Hedging Make Sense

Currency hedging is best applicable in certain investment scenarios where protecting returns from exchange-rate swings is a priority.

• Short- to medium-term: Investors with shorter holding periods are more susceptible to short-term currency fluctuations. Hedging is a viable instrument to reduce unforeseen losses.
• Income-oriented or capital protection objectives: For portfolios aiming to generate stable income or protect principal, currency hedging helps ensure that adverse exchange-rate movements do not erode earnings or savings.
• High currency volatility: During times when currencies are undergoing significant fluctuations because of economic, political, or market factors, hedging can reduce volatility and safeguard returns.
• Home-currency-biased investors: Home-currency-biased investors are those who are more interested in the performance of their home currency and will hedge to ensure that they can predict the results, instead of taking on more currency risk.

When Staying Unhedged is Favourable

Currency hedging can help minimize volatility, but being unhedged may also be favourable for some investors in certain circumstances.

• Long-term equity investors: In the long-term, currency fluctuations tend to equalize. Staying unhedged gives the investor the potential to gain market returns in addition to currency appreciation.
• Seeking diversification benefits: Unhedged exposure provides an additional level of diversification since currency movements are not related to equity market performance. This can assist in the smoothing of aggregate portfolio returns in the long run.
• Currency movements that counter market risk: In other situations, a depreciating local market can be partly countered by a strengthening foreign currency, which offers an automatic cushion against losses.
• Structural role of reserve currencies: Unhedged positions in major reserve currencies, such as the USD, can be less risky in global portfolios. Investments in these currencies are less volatile than investments in emerging market currencies. However, all currency exposures involve risk.

Conclusion

Currency risk is an inseparable component of global investing, and it influences returns regardless of market performance. Hedging is a risk management instrument that not only minimise volatility but also helps manage currency risk.

While a suitable strategy will depend on individual investment objectives, risk tolerance, and financial circumstances, investors should ensure that any platform or service provider they use is appropriately regulated and that the products accessed are suitable for their needs. Access to multiple global exchanges and financial instruments does not remove investment risk. Dealing.com offers you access to 9 major global exchanges and 30K+ assets through one single account. This allows you to explore markets and equities based on personal goals and comfort.

Disclaimer: This content is for educational purposes only and does not constitute investment advice, personal recommendations, or a solicitation to buy or sell financial instruments. All investments involve risk, including potential loss of capital. Investors should consult professional financial advisors and consider their personal circumstances before making any investment decision.