Understanding Currency Hedging

Currency hedging is one of those things people tend to bring up but never really explain. They’ll say vague statements why they are for or against hedging and if you don’t have an understanding of the process then you are left in the dark.

What is currency hedging?

Currency hedging is an attempt to try and minimize the risk associated with currency fluctuations on foreign investments. When you buy a stock in a company in a another country you are essentially doubling your risk. Not only are you at risk that the stock could go up and down but that the exchange rate between your currency and the foreign currency can work against you. Hedging is an attempt to manage that risk. An example of the currency risk:

Sally The Fund Manager goes and buys 1 share of CompanyX for 10$ USD. At the time the exchange rate is $2 CAD = $1 USD so it would have cost her $20 CAD. After some time Sally decides to sell her position in CompanyX. To her surprise the stock has doubled and Sally sells the share for $20 USD.  Unfortunately to her surprise the exchange rate has changed as well and the Canadian dollar is now on par with the American dollar ($1 CAD = $1 USD). In the end Sally still ends with $20 CAD even though her investment doubled.

Who can hedge?

Generally speaking anyone can perform currency hedging though it’s more difficult for the individual investor since most currency hedging is done with complicated investment instruments. This leaves most  hedging to mutual funds, ETFs, hedge funds and larger institutional investors.

How is currency hedging achieved?

Larger investors (Mutual funds, ETFs, hedge funds, etc.)  use derivatives such as options and futures. These are contracts that allow an investor to buy or sell currency at a pre-determined exchange rate at some point in the future. Lets go back to our example with Sally The Fund Manager:

Prior to making the investment Sally The Fund Manager decides to sell a futures contract to provide $20 USD at a rate of $1.75 CAD = $1 USD to Bob The Hedge Fund Manager (Bob is betting the US currency will go up).   What this means is at the end of the contract Sally will give Bob $20 USD and Bob will give Sally $35 CAD. When Sally goes to sell Company X stock she also has to meet her obligation on the futures contract. Because the exchange rate is $1 CAD for $1 USD she buys $20 USD for $20 CAD. She then gives Bob the $20 USD and Bob gives her $35 CAD. Sally has made $15 from the futures contract plus the money she has earned from her investment.  In total Sally has made $35 CAD from her investments. Though she didn’t end the with $40 CAD she would have earned at the original exchange rate she did protect a large portion of her return with hedging.

Now what would have happened had the exchange rate gone to $2.50 CAD for $1 USD. Well Sally would have had to buy $20 USD for  $50 CAD. She would then give Bob the the $20USD and he would give her $35 CAD. This turns out to be a loss of $15 dollars for Sally. However this loss is offset by the additional profit from selling the CompanyX  stock. She earned $50 CAD dollars from the stock sale subtract the $15 dollar loss from the futures contract and Sally’s return is still $35 CAD.

This is great I want investments with hedging

Wait one second. The example I gave makes hedging seem like the greatest investment tool ever. There are a few points that make hedging a less attractive strategy:

  • Fees –  There are fees and premiums when buying or selling these futures’ contracts and those tend to get passed on the the investor in the way of a more expensive MER.
  • Tracking Issues – Canadian Capitalist points is out that even though the difference in MER between a hedged index fund and a non-hedged index fund was only %0.15 the hedged fund underperformed the non-hedged fund by over 2% on a yearly basis.
  • Magnifying Losses -Even though the purpose of hedging is to limit your currency risk there is still some degree of “double risk”.  There is the possibility that the stock you bought could go down and at the same time the the exchange rate could make you loss money on your hedging strategy. This would make your losses far worse then if there was no hedging at all.
  • Limiting Diversification – This final point is up for debate depending on who you ask. Some people will say that all of your investments should be in currency of the country you plan to retire in. However believe (so do I) that a little currency diversification is part of a healthy portfolio. If you buy funds or ETFs that hedge then you are removing that diversification.

So is hedging right for me?

This is a tough question that can really only be answered on a case by case basis. You would need to look at your risk appetite, investment time horizon, and your retirement goals. Though in the past it appears that if you have a long enough investment time horizon (15+ years) then there is no benefit to being hedge or un-hedged. This may not always be the case going forward so the choice is up to you.