Let’s start at the beginning: what is
currency hedging (CH)? If we just go straight for the basics then it is a
situation where investors have assets in countries where they are not
resident and so use CH to try and protect themselves from any fluctuations
(especially sudden ones) in the foreign currencies and how they will affect
the money invested when it is valued in the home currency of the investor.
These changes in the different value of currencies can be caused by various
things such as economic fundamentals et al. CH should limit the effect of
any wild shifts in exchange rate valuations.
The benefits of hedging are very much reliant of the aims
of the investor and the currencies being hedged.
Working out the cost of hedging is also very important. If any potential
hedging is only a small part of a portfolio then the costs of setting up the
hedge may well not be worth it. Costs include payments to currency dealers,
banks and investment managers. These costs are for such things as:
- Bid/Offer spreads
- Rebalancing the actual hedge back to within the acceptable parameters
- Liquidity in a particular currency
- Offsetting risk, i.e. such things as a default, etc.
The next question is if there is such a thing as the
perfect hedge ratio? As with almost everything in the economic world there
are a number of varying opinions on this one. They range from people saying
that no hedge is best to others saying that a portfolio can only achieve
optimal performance if there is a total hedge. What it basically comes down
to, though, is the investor’s risk/reward ratio and over what time period
any portfolio is going for.
One other thing that is vital is for the investment to be
monitored regularly. If everything with the hedge works well then the
investor will be guarded against inflation, market volatility (especially
commodities), changes in interest rates, and forex fluctuations. That is all
the good news. The downside of hedging means that people may not be as
liquid as they would wish to be. It must also be remembered that the idea of
a hedge is to minimize risk, therefore, by nature this will potentially
As a simple example, let’s look at what happens when you
compare the US Dollar against the British Pound in the marketplace. So,
should a Sterling-based investor have the same global equity exposure as a
US Dollar-based investor?
As most people know, the American US equity market makes up nearly 50% of
global equity whereas the British one is only around 10%. This obviously
shows that there is less need for an American to hedge than a Brit. But what
about the levels of volatility, are they the same and can worldwide access
give a better rate of return? If you look at figures 1 and 2 you can see
that, apart from a couple of short term differences, the volatility for both
American and British investors with access to world markets is roughly the
However, where things do start to differ are on a one or
five year interval as these can show large differences in the rates of
return. Figures 4 and 5 show this as these charts show hedged being USD
returns and un-hedged are in GBP terms.
It is noticeable that at the height of the crisis in 2008, the Morgan
Stanley Capital Index (MSCI) World Annual rolling returns were down only 25%
in GBP terms as opposed to minus 50% in US Dollars. This was mostly due to
how weak the British pound was five years ago. The five year chart indicates
exactly how returns can vary on a large scale, i.e. the five year period
ending in 1985 shows a GBP return of 160% as against only 60% in US Dollars.
So what does all of this indicate? Well, an investor needs to know what
his/her risk/reward ratio is and the length of time that the investment is
needed as it is obvious that any swings over longer periods of time even
themselves out. However, on the downside, they can distort monthly returns
significantly. Hedging definitely has its place in the market and can
protect an investor dramatically. However, it can also cause chaos in the
wrong hands. Caveat emptor!
The above data and
research was compiled from sources believed to be reliable.
However, neither MBMG International Ltd nor its officers can
accept any liability for any errors or omissions in the above
article nor bear any responsibility for any losses achieved as a
result of any actions taken or not taken as a consequence of
reading the above article. For more information please contact
Graham Macdonald on [email protected]