To hedge or not to hedge, that is the question

(Image credit: Getty Images)

Rising fears about the outlook for the dollar may make it more compelling to hedge currency exposure. This is not just a theory: investors are increasing hedges on their US holdings.

To recap, forward currency rates (ie, the rate at which you can commit to buy or sell a currency at a fixed point in the future) are mostly driven by expected interest rates. If they weren’t, we could borrow in one currency, invest it in another at a higher rate and lock in a future exchange rate to repay the loan without taking the risk that currencies will move against us.

So, if the sterling-euro rate today is €1.14, the one-year sterling swap rate is 3.8% and the one-year euro swap rate is 2.1%, then the forward rate for sterling-euro in one year should theoretically be about (1.14 × 1.021) ÷ 1.038 = €1.12.

MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Real life isn’t so simple – other factors also affect the price of forwards. These range from frictions such as taxes to imbalanced demand between a pair of currencies (eg, more demand for US dollars). This difference between what interest rates imply and market prices is known as the cross-currency basis.

In some cases (eg, emerging markets), the real cost of hedging is often far more than theory suggests. However, for major developed-market currencies, costs should be tolerable – although, hedging strategies in a currency-hedged fund may not give perfect results.

Relative returns

From the example above, we can see that if the expected interest rate in the UK is higher than the interest rate for the foreign currency, then forward exchange rates for sterling should be weaker (and vice versa).

It follows that when our interest rate is higher, then investing in a foreign-currency asset and hedging the currency should give us higher returns than a local investor in the same asset gets. That’s because we get the same return in local-currency terms, but we also pick up a currency gain – since the forward rate for sterling is weaker, we get more sterling back when we close the trade.

However, this only applies when comparing our hedged returns with local returns. What we care about is whether we get better returns in sterling by hedging or not, and this depends on how exchange rates subsequently change. If our currency weakens, we are better off not hedging. If it strengthens, we are better off hedging.

One easy error here is to assume that forward rates are a useful predictor of where exchange rates will go in the future. They are not – they are a market rate that permits hedging while preventing risk-free profits, but they have little forecasting power. In reality, currencies are highly unpredictable.

So, one simple rule of thumb is to hedge exposure on bonds (where the moves in exchange rates can easily swamp interest returns from the bonds), but only hedge stocks in exceptional situations. Given that US stocks account for 60% to 70% of most global funds, the debate now is whether the risks to the US dollar are becoming exceptional.

This article was first published in MoneyWeek's magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.

Cris Sholt Heaton is the contributing editor for MoneyWeek.

He is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is experienced in covering international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers.

He often writes about Asian equities, international income and global asset allocation.