To Hedge or Not to Hedge: Currency Hedging and International Investing
As economies, markets, and companies become increasingly global, many investors are including foreign investments in their portfolios. Foreign investing introduces the additional dimension of currency exposure into the return equation: for a US investor, the return on any investment in a foreign market is equal to the return on the investment in local currency plus the return of the foreign currency relative to the US dollar. When the dollar is strong relative to the foreign currency, this can hurt total return, as the local currency translates into fewer dollars.
Recent US dollar strength (the dollar was up nearly 20% between July 2014 and March 2015), has many investors arguably more focused on foreign exchange risk, and wondering what to do about it. Through hedging, investors can potentially mitigate the impact of foreign exchange movements on portfolio returns.
In this article, we evaluate hedged and unhedged equity performance using the Sharpe Ratio, which is calculated as the average excess return (return of the portfolio less the risk-free rate) divided by the standard deviation of the portfolio return. The Sharpe Ratio measures risk-adjusted performance and allows us to compare equity portfolios with different levels of risk.
When evaluating whether or not to hedge foreign equities, the following criteria may be useful:
- Does hedging increase risk-adjusted returns? If so, does the benefit come from higher average returns, lower volatility, or both?
- What are the costs of hedging? How does the hedging cost change depending on market conditions?
- What are the implementation issues associated with hedging?
This paper takes a critical look at foreign exchange hedging to understand the benefits and limitations of using such instruments to build international equity portfolios for clients. It then turns to a brief discussion of hedging as it relates to non-US bonds.