To hedge or not to hedge, that is the question

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.

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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.

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