Peering through the hedge: BlackRock’s view on currency hedging
An important aspect of investing in nondomestic assets or markets is the role that foreign exchange plays in the implementation of a strategy and the value of total returns that are generated
Exchange rate fluctuations increase the risk associated with foreign currency denominated investments, and high levels of volatility over the past couple of years, coupled with a rising interest among investors in economies with stronger growth prospects (including emerging markets), have raised awareness of the impact that exchange rate movements can have on the total return of foreign assets once returns are converted in the domestic currency.
Hedging a portfolio
In an international portfolio, the reduction in risk from hedging foreign currency exposure should be considered from the perspective of the entire portfolio, rather than just evaluating the international portion in isolation. Among the factors to take into consideration when designing a hedging strategy for a portfolio include the proportion of international exposure within a portfolio (and the characteristics of those assets), transaction costs, the investment horizon, an estimate of the historical correlation of all of the assets in the portfolio and the investor’s risk tolerance.
When are investments likely to be currency hedged?
There has been some debate about whether currencies yield a long-term return. Academic evidence is mixed but it is generally accepted that, in the long run, currency changes are offset by interest rate differentials – one of the cornerstones for forward pricing, swaps and derivatives. However, even if long-run currency returns are zero, shortrun returns are volatile and could dominate the returns from an underlying asset. Over short investment horizons, market sentiment can drive asset or market moves, which may contribute towards driving asset performance correlations. Over a longer period, however, fundamental factors play a more prominent role in determining asset performance and correlations. For this reason, currency hedging may play a more important role over shorter rather than longer time horizons.
International fixed income portfolios are likely to include a greater degree of currency hedging than equity portfolios due to the different characteristics of the two asset classes. Currency returns over the longer term tend to be driven by fundamentals such as expected interest rate differentials and purchasing power parity, while corporate earnings drive equity markets. Although macroeconomic conditions are certainly a key factor in earnings growth over a longer time period, the correlation between currency and bonds returns is higher than that between currencies and equities, as currencies and bonds tend to react to the same fundamentals such as inflation expectations. For example, between 1988-2006, assuming the US dollar is the local currency base, currency hedging significantly reduced the volatility of bonds, while the impact on equity markets was both less significant and not always beneficial (JP Morgan, MSCI).
The cost of currency hedging is a key factor in determining whether it is used, what proportion is hedged and even how the hedge is implemented. It seems fairly obvious that when transaction costs are low, the optimal hedge ratio will be higher. Even for investors seeking to minimise risk (volatility), hedging entails some limitations. Full or even partial hedging eliminates or reduces the potential short-term gains from tactical trading by fund managers. Furthermore, it can also impose substantial cash flow requirements during periods of extreme market stress. For example, in 2008 some investors were forced to liquidate underlying assets to fund the cash flow obligations of a currency hedging programme.
To hedge or not to hedge?
Currency hedging can play a vital role in reducing risk, smoothing returns, reducing exchange rate volatility and increasing the predictability of the value of returns. However, the trade-offs for these benefits include the transaction costs associated with hedging, the opportunity cost in not using that money for other investment purposes and the diminution of the potential gains from a favourable movement in the exchange rate. Investors, therefore, face a decision - whether or not to hedge their foreign currency exposure and, if so, how much of the exposure they should hedge.
Research in this document has been produced and may been acted on by BlackRock for its own purposes. The views expressed herein are as of May 2012 and do not constitute investment or any other advice; the views are subject to change and do not necessarily reflect the views of BlackRock as a whole or any part thereof. All financial investments involve an element of risk. Therefore, the value of your investment and the income from it will vary and your initial investment amount cannot be guaranteed. Past performance is not a guide to future performance and should not be the sole factor of consideration when selecting a product.
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