Global diversification has become standard practice among investors around the world. As the trend toward global investing grows, managing currency risk in global portfolios is likely to take on increasing importance. Sovereign wealth funds, central banks and other investors are likely to consider the benefits and challenges of currency hedging as their investment strategies become more globally focused. However, evaluating the impact of foreign exchange risk on portfolios and how to address that risk is a debated issue. Should global investors adopt strategies to specifically address currency risk or should they not?
There is no universally correct answer to this question. Rather, when determining whether to hedge currency risk or not, investors should consider their own individual investment objectives and risk preferences. Risk factors related to the constituents of the underlying portfolio must also be considered when formulating the appropriate strategy. Because risk factors differ according to each portfolio type and must be evaluated by each individual investor, it is difficult to argue broadly for or against currency hedging. In this blog post, we provide investors with a simple roadmap to guide their decision-making process.
Four simple questions
The opportunity set of hedging options facing investors is fairly straightforward. However, the decision of whether or not to hedge and what approach involves many considerations based on the investor’s investment objectives and risk preferences. We provide a list of four simple questions that investors can ask themselves to help determine whether hedging is desirable and what type of hedging strategy may be appropriate for them.
Answering the following four questions can help determine an appropriate currency management strategy:
What is the source and nature of currency risk to be managed?
- Investors can start by asking, what is the underlying asset class at risk from currency movements? For example, fixed income returns are especially vulnerable to currency volatility, especially at current low prevailing yields. Many equity investors, on the other hand, view unhedged portfolios as a way to preserve diversification.
- How predictable is the investment’s future cash flow? The more predictable a portfolio’s cash flows are, the easier it is to hedge effectively. A typical fixed income portfolio, for example, can be hedged with contract maturities synchronized around set coupon payments. However, if the asset class in question generates inconsistent cash flows, such as real estate or private equity investments, then the hedge may not be as simple or exact.
What is the desired hedging ratio?
- The desired hedging ratio (the portion of the portfolio that is hedged relative to the entire portfolio) will depend in part on the investor’s “hedging budget.” Currency hedging, like buying insurance, has a cost and this cost is deducted from investment returns. Hedging costs are largely driven by the interest rate differential between the home and foreign currencies.1How much an investor is willing to spend on attempting to reduce currency risk is his or her “hedging budget.”
- The hedging budget helps determine the preferred hedging ratio. Possible hedging ratios span between 0% (no hedge) to 100% (fully hedged). Aside from cost, the investor’s own level of “risk aversion,” or preference for certainty, is another important factor in determining his or her hedging ratio. The higher the preference for certainty, the more likely an investor is willing to pay a higher cost to reduce risk.
In the case of active currency management, what factors are likely to cause changes to the hedging strategy over time? In a passive strategy, what factors determine the passive hedging ratio?
An investor in an active currency management strategy may need to ask, what are the modulation criteria? In other words, what are the criteria that will trigger changes to the hedging strategy over time? These criteria can be broadly grouped into the following categories:
- Macro driven – Macro views may drive currency selection or the hedging ratio. For example, an outlook for a particular currency may drive investment and hedging decisions.
- Carry biased – Interest rate differentials between the home and foreign currency may drive hedging decisions. Investors may seek to minimize the drag on returns due to hedging costs.
- Volatility target – Comfort with certain volatility levels may determine hedging decisions. For example, consider a portfolio that generates 10% volatility of returns due to asset prices only and 5% due to currencies. If a tolerable level of volatility is 10%, hedging strategies could be adopted to eliminate the additional 5% volatility generated by currencies. However, we believe it is important not to adopt across-the-board currency strategies. Rather, it is important to take into account the correlation of each currency to each underlying security in the portfolio, meaning each currency’s sensitivity to the underlying portfolio constituents.
An investor in a passive strategy may determine his or her passive hedging ratio based on the three criteria above or based purely on preference.
What is the operational set-up?
- Any currency-hedged strategy requires cash management tasks and capabilities. These capabilities and tasks include foreign account settlement capability, the establishment of credit lines and derivatives documentation, for example.
Currency hedging is not a one-size-fits-all strategy. Investor risk appetite, asset class characteristics and portfolio objectives all enter into the decision of whether or not to hedge. Choosing an active or passive approach is further dependent on individual investor criteria.
We have provided a simple roadmap to guide the hedging decision as well as to selecting the basic approach. By answering the four questions outlined above, investors can start on the path to determining the currency management strategy most appropriate for their portfolios.