Should investors hedge currency risk?
In a new whitepaper, John Southall investigates the question of how the strategic currency hedge ratio should depend on the time horizon.
The below is an excerpt from our new whitepaper, FX for the long run?
With some potential exceptions[1] we consider it to be a good idea to currency hedge global bonds. This almost always reduces risk significantly because currency volatility is usually high relative to bond volatility. However, results are no longer clear-cut when we look at risky assets such as equities. Equity returns are inherently more volatile, and currency movements often interact with them in complex ways rather than remaining independent.
From a short-term risk perspective, it can make sense to adopt low FX hedge ratios of equities from relatively safe-haven areas, where ‘relative’ means compared with your base currency. These currencies – such as the Swiss franc, Japanese yen and US dollar – tend to appreciate during periods of equity market selloffs, providing an offsetting effect.
Conversely, it is theoretically optimal to apply higher hedge ratios for currencies from relatively risky regions, as they are more likely to depreciate during market downturns.
We use the word ‘theoretically’ because, in practice, hedging very risky emerging market currencies is rare.
Sterling sits between safe-haven and EM currencies, often viewed as moderately pro-risk. For UK-based equity investors, a balanced approach – implementing a partial hedge of currency exposures – can be a sensible compromise.
In our whitepaper we examine data going back to 1926 to test whether the theory holds, as well as probing possible economic rationales that could support lower hedge ratios over longer time horizons.
Discover our findings in the new whitepaper: FX for the long run?
[1] Exceptions can include high-yield bonds (as they can be more equity-like) or local currency emerging market debt given expected real exchange rate appreciation of emerging market currencies.
