Why should an Investor deploy Currency Hedging Strategy?

The world wide integration of the financial markets no doubt has lead to diversification of business and significant return on international investments. The potential of high yield is enticing, but it also brings with it potential risk which is the by-product of dependency on foreign currency. The dollar is going strong in comparison to other currencies, which is beneficial for US visitors, but not for the investors. The conundrum of hedging or not hedging of the currency continues to give sleepless nights to the investors.

If we consider the underlying economics of currency exchange, if a foreign investor invests in dollar, he will get return in local currency; if it is converted in US dollar it will not have much return when the dollar is strong. A weak dollar will boost international returns. If we observe the dollar currency performance in the chart below, it clearly shows US economy is growing and leading other developed economies. It has led to high-interest rates, difference in income for dollar investors and escalating trade tensions in developing nations. All these factors have furthered strengthened the US dollar.

Now the question arises, is it prudent and frugal to invest without hedging considering the international exposure and strengthening of the dollar?

Pros of Currency Hedging

Restricting the Fluctuations

The exchange rate fluctuations can result in risk or reward on the cross border currency investments. With the rising dollar, the Non-US investors are not in a rewarding position, but with the hedging of currencies, one can manage or limit the fluctuations. The higher return on investment by reducing risk will help the investor in investing liberally as the peer comparison will be improvised and have a positive impact on portfolio performance.

Mitigating the risk on international investment

Converting the currency may result in a drop in net returns that goes in your pocket. Currency Hedging can minimise that risk as it insulates the investment from the currency fluctuations leading to loss. How does it mitigate the damage? By providing a pay-off which primarily is based on rising and fall in dollar. E.g. the pound is weak due to the decision of the United Kingdom to leave the European Union with or without any deal, but the equity market is still growing. Why is that? It is because their hedged investments outscored by 6.5% point in comparison to unhedged investments.

Defined benefit pension fund

If an investor can make the efficient use of risk by managing the currency exposures, it can help in achieving a level in funding. A Defined benefit pension fund matches the liabilities and assets of the investor and currency investments are a liability that can be matched with the hedging of the currency. The cost of levelling the mismatching by hedging is relatively less than the gains of asset allocation.

Cons of Currency Hedging

Letting go of perks CCR

When the Currency Conversion Rates are not favourable, currency hedging will reduce the risk and loss. On the contrary, when the rates are in your favour, then you have to forego the bonus that could have been added in your return.

Impact on Bonds over Equities

As the rate of returns is fixed on bonds, a fluctuation in currency can significantly affect its return. Whereas, equities are volatile in nature and won’t have any major effect if the hedging is added. Bonds being stable in nature will become volatile with currency hedging. A point to note here is that, if investment in foreign bonds is less than the cost of hedging, then it will not be a good idea.

Hedging Cost

Investors need to pay for covering the risk on their foreign investment. It starts with the commission of investment manager, then custodian bank that is doing record-keeping for you and of course the currency dealers who are doing hedging for you. So, it is essential to consider that is the investment worth the hedging?

The Verdict

Hedging currencies is a smart move when the dollar is strengthening, but at times unhedged currencies provide the benefit of a diversified portfolio. It happens at the time of negative equity-FX correlation. Therefore, before hedging the currencies, an investor should scrutinise their portfolio and weigh out the impact of foreign investment on it. If the investor has a gut feeling that unhedged currency will have positive implications considering social-economic, geopolitical factors and market fluctuation, then he can opt out of hedging or vice-versa.