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Currency exchange rates can improve or reduce investment returns when translated into your home currency. But hedging an international investment will limit the effect of exchange rate fluctuations.

A decision to hedge will seek the return of the underlying investment only, minus expenses (including hedging costs). It’ll also forgo positive or negative returns from a currency’s relative strength or weakness.

Which is best?

Your client must decide whether to hedge equities or bonds.

In the case of bonds, currency exposure adds significant volatility to an asset that is relatively stable in price. Stocks, on the other hand, already have high volatility, so the effect of adding currency volatility is less pronounced.

For international stocks, the benefit of hedging is smaller, while the costs remain the same. Meanwhile, the benefits of hedging currency risk in international bond portfolios generally outweigh the costs (see “Hedging currency risk,” below). Some products charge an extra fee for hedging. The cost for large investment providers that can leverage their size will likely be less. And some providers may choose to absorb the cost, letting the investor decide solely on hedged or unhedged. The benefits of hedging also depend on the investor and the currency.

Hedging currency risk has much greater impact in bonds than in stocks

Hedging currency risk chart

Sources: Thomson Reuters Datastream, Barclays Capital, Citigroup, Dow Jones, MSCI, Vanguard

The importance of cost

Cost is an ever-present risk to performance and should be at the heart of your client’s decision. If foreign securities represent a small percentage of his or her portfolio, the cost of hedging may outweigh any benefit.

These costs can include compensating currency dealers for facilitating hedging transactions, custodian banks for recordkeeping and investment managers for maintaining the hedge.

Factors affecting costs can include bid-ask spreads on currencies and the frequency of rebalancing the hedge back to the desired ratio. Cost estimates can range from four to 20 basis points.

Other risks that affect costs, and therefore performance, include:

  • Currency liquidity – Some currencies, such as emerging markets, have lower trading volumes than others and may be difficult to hedge, especially in times of financial turmoil;
  • Counterparty risk – Currency exposure is typically hedged through currency forward contracts. Buyers and sellers negotiate these contracts, so a counterparty’s creditworthiness and ability to fulfill an agreement are important; and
  • Settlement risk – An element of counterparty risk, this is the possibility that one party will default after others have fulfilled their obligations.

Is there an optimal hedge ratio?

Especially with stocks, there’s no consensus on whether an optimal hedge ratio exists or what this value may be. Various researchers have set the hedge ratio between 0% and 100%.

On one end of the hedging spectrum is the fully hedged portfolio. Some industry experts argue that since currency hedges lower portfolio risk but not return, the full hedge is essentially a free lunch.

At the opposite end is the un- hedged portfolio. Advocates of this approach believe that if real exchange rates and asset prices display mean reversion, then the decision to hedge depends on the investor’s investment horizon. For longer horizons, the unhedged portfolio may be optimal.

With a partial hedge, only some of the foreign-currency exposure is hedged back to the investor’s domestic currency.

The optimal hedge ratio is a function of the investor’s risk tolerance, her beliefs about the movements of currencies and asset prices, and the objectives of the currency hedging decision.

How to evaluate your decision

It’s essential to know why your client has chosen to hedge (or not), and to keep those reasons in mind when evaluating the strategy’s effectiveness.

If managing risk is your client’s goal and she chooses hedged investments, it doesn’t matter if an unhedged strategy would have provided superior returns. Similarly, if your client wants to enhance returns by not hedging, explain that greater potential reward brings greater risk.

Atul Tiwari is managing director of Vanguard Investments Canada.

Originally published in Advisor's Edge Report

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