Currency Futures to Hedge Currency Risk

Currency Futures to Hedge Currency Risk

A key difference between investing in domestic and foreign assets is that the latter exposes the investor to a currency risk. Over the years, most investors have not been careful in characterizing this risk to returns from unhedged portfolios. One simplistic view was to measure the return in domestic currency terms and compare it with returns in local currency terms, and characterize the difference as the “currency effect.” The reasoning was that if the exchange rate remains constant from the time of purchase of the foreign asset to its sale, then the currency risk has had zero impact. On the other hand, if the domestic currency has weakened (strengthened) against the foreign currency, the exposure would result in a gain (loss).

Over the years, there has been considerable controversy on this question. As might be expected, there are multiple viewpoints regarding the relative merits of hedging away currency risks. Here are a couple of classic arguments in favour of not hedging.

Uncorrelated risks

On a historical basis, changes in exchange rates (and hence currency returns) have had very low correlations with foreign equity and bond returns. The belief is that this lack of any systematic relationship could in theory lower portfolio risk.

Expected returns are zero

Viewed over a long investment horizon, currency movements cancel out each other – the mean-reversion argument. In other words, exchange rates have an expected return of zero. So why bother hedging against currency surprise.

The arguments in favour of hedging are as follows:

How long is the long-run?

Financial planners advice their clients to pursue buy-and-hold strategies. If one trades with the attitude of “investing for the long-run”, ignoring short-term dynamics of currency returns could be a perfectly valid strategy. Folks who invest other peoples’ money, fund managers, though tend to be compensated on their quarterly performances relative to...