The Role of Currency Hedging

For many investors, foreign currency hedging remains an offputting, if not alien concept. It may seem an overly exotic play. But there are a number of reasons why investors may choose to invest, or hedge, in foreign currencies. These include both risk management and speculative demands.

Many investments are linked to foreign currencies: interests in foreign companies, or bonds, or stocks of global companies. It’s difficult not to have some exposure to the prices of foreign currencies. Businesses who import supplies or products are obviously affected by the exchange rate.

How is hedging accomplished? Let’s assume that an equity investor chooses to minimize risk in his portfolio by using fixed currency weights. His objective is to hold currencies which have negative correlations to her equities. This should minimize his risk. Therefore she shorts currencies which have a positive historical correlation to her equity portfolio, and takes long positions in the currencies with positive correlations.

In considering her approach, her advisor points out that the of the major economies around the world, the most commodity-dependent are the Canadian and Australian. This is proven out when looking at equity prices around the world. They tend to rise with the Canadian and Australian Dollars.

An Economist’s Explanation of Currency Hedging

In international equities, an unhedged position would be equivalent to a long position in foreign currency, with a value equal to the equity holding. On the other hand, a position which is fully hedged has a “null position” in foreign currency. For example, if a the demand for a particular currency is expected to rise above all currencies simultaneously, then of course the investor will take a long position. Risk management demands for foreign currencies reduce to zero when currencies and equities have no measurable equivalence in their values. Since hedging in foreign currencies often plays a speculative role it’s important to note that the best time to fully hedge when speculative trading is minimal.

How Banks and Institutions Hedge Currencies

Central banks have traditionally held their “reserve currencies” in the US Dollar, the Swiss Franc, and the Euro. These currencies tend to have negative correlations with equity prices. When equities fall in value, the values of these currencies tend to rise as investors “flee to quality.”

Gold, Silver and other metals are of course not considered currency, but they may represent the ultimate in safety. (Some funds listed in The Review will trade futures on these metals).

Bond investors face another consideration: Their bonds are almost uncorrelated with the price of currencies. Therefore, bond investors seeking to minimize risk should avoid holding currencies. In other words their international bond positions should be fully currency- hedged.

Institutional investors routinely employ this risk model. One exception to this method is the US dollar. It tends to rise in prices when bond prices fall (i.e. when interest rates rise). This negative correlation generates a modest demand for the dollar. And, if no domestic assets can be considered without risk, then we might see a risk management demand for foreign currency.

At the time of this writing, hedging in virtually any foreign currency requires particular diligence. “Euroland” is particularly sensitive. (Think of Euroland as a virtual country, including Germany, France, Italy, and the Netherlands). These countries have the longest history of documented exchange rates, stock returns, and interest rates. They are thus the most important players in decisions regarding the Euro.

In looking at the stock market declines of 2008, reserve currencies such as the US dollar as well as currencies having low interest rates such as the Japanese yen have tended to strengthen against other currencies. During this period, countries more dependent on commodities, such as Australia, saw the values of their currencies decline. At the same time, government bonds moved opposite to stocks. Thus the currency hedge also worked for bond investors.

Currency Hedging as a Trading Strategy

In managed accounts, virtually all trades are “hedges” in the sense that the value of one particular currency is expected to rise or fall against another. However, most currency traders are going for short-term positions against which there are no assets other than the account holder’s funds.

Wealthy investors should consult with a respected advisor in planning any hedges. Such hedges would normally be geared on a .5:1 or 1:1 ratio.