Currency Hedging: The Decision Most International Investors Make by Accident

Buy shares in a foreign company and you have made two investments, whether or not you meant to.

You own the company. You also own the currency it is priced in - because when you eventually sell, the proceeds must convert back to the money you actually spend.

Most people never decide about the second one. Not deciding is a decision: it means fully exposed.

The two components

An international investment return breaks into two parts.

Asset return - what the investment did in its own currency. Currency return - what that currency did against yours.

They are independent and either can dominate.

A foreign holding can gain 15% in local terms while its currency falls 15% against yours, leaving you roughly flat. Or it can be flat locally while the currency gains 10%, and you are up 10% on an investment that did nothing.

Over short periods, currency frequently dominates. Exchange rates between major currencies routinely move more in a year than a diversified bond portfolio earns.

How hedging works

The standard instrument is a forward contract - an agreement to exchange currency at a fixed rate on a future date.

A fund holding foreign assets sells the foreign currency forward in an amount matching its holdings. If the currency falls, the assets are worth less in home terms but the forward contract gains, and the two roughly cancel. If it rises, the reverse.

Forwards have fixed dates, so the position is rolled - commonly monthly. Because asset values move between rolls, the hedge is never perfect. It is an approximation that removes most, not all, of the currency effect.

What it actually costs

This is where intuition usually goes wrong. The dominant cost is not a fee.

Forward exchange rates are determined by the interest rate differential between the two currencies. This is not a market forecast - it follows from arbitrage. If it were otherwise, you could borrow in one currency, deposit in the other, hedge the exchange risk and earn a riskless profit.

The consequence for a hedger:

Your currency has higher interest rates than the foreign one - hedging typically adds to your return. You are effectively earning the differential.

Your currency has lower interest rates - hedging typically subtracts. You are paying it.

This can be a substantial figure. When rate differentials between major currencies are wide, the annual cost or benefit of hedging can exceed the expected return on the underlying bonds entirely.

Transaction costs sit on top and are small by comparison for major currencies.

The important implication: the cost of hedging changes as interest rates change. A hedge that was profitable can become expensive without anything about your portfolio changing.

When it is worth doing

The answer differs sharply by asset class, and the reason is the ratio of currency volatility to expected return.

International bonds - usually hedge. A high-quality government bond might be expected to return a few percent a year with modest volatility. Currency movements of 10% or more in a year are routine. Unhedged, the currency is not a side effect - it is the dominant driver, and it overwhelms the stability that was the point of holding bonds. Most institutional practice hedges international bond exposure for this reason.

International equities - genuinely arguable. Equity volatility is already high, so currency adds proportionally less. There is also a partial natural offset: companies with global revenues see earnings rise in local terms when their currency falls, which cushions the translation loss. Sensible practitioners disagree about this, and both hedged and unhedged approaches are defensible.

Commodities - usually already dollar exposure. Most are priced in dollars regardless of where they are produced, so the currency exposure is to the dollar, not to the producing country.

The arguments against hedging

Worth taking seriously rather than treating as an oversight.

Currency exposure is diversification. Home currency weakness is often associated with domestic economic trouble - exactly when foreign currency exposure helps. Hedging removes that offset.

Long horizons may reduce the need. Over very long periods, currency effects have historically been smaller than over short ones, though this is a weaker regularity than it is often presented as.

It costs money when differentials go against you, and that cost is certain while the benefit is uncertain.

It adds complexity - hedged share classes, rolling positions, tracking differences that need explaining.

Where you spend matters most

The question that resolves most cases is rarely asked: what currency are your future liabilities in?

Someone who will retire in their home country, spending home currency, has home currency liabilities. Foreign currency exposure is genuine risk relative to what they actually need.

Someone who plans to live abroad, or has children studying overseas, or holds substantial foreign obligations, has liabilities in other currencies. For them, some foreign exposure is a hedge, not a risk.

Currency risk is only meaningful relative to what you will eventually spend. That framing settles more of these decisions than any volatility statistic.

Practical points

Check what you own. Many funds offer hedged and unhedged share classes of an identical portfolio. Which one you hold is often accidental.

Compare the two versions over several years. The gap between them is the currency effect plus hedging cost, shown directly.

Do not switch based on a currency view. Hedging as a policy is risk management. Hedging when you expect a currency to fall is a currency trade, and should be recognised as one.

Revisit when rate differentials shift substantially, because the economics change even if nothing else does.

The bottom line

International investing gives you two exposures. Hedging removes one of them, at a cost driven by interest rate differentials rather than by fees.

For bonds it usually makes sense, because currency moves can be larger than the entire return you were seeking. For equities it is a legitimate judgement call. What is not a judgement call is making the decision deliberately - because holding an unhedged foreign fund without thinking about it means running a currency position you never chose.

This article is educational and is not financial advice. Currency markets are volatile and the value of international investments can fall as well as rise.