EC Life In A Low-Return World: To Hedge Or Not To Hedge?

We believe we will see low returns over the next seven to ten years. Pension funds, endowments and individuals may have to adapt their behavior and strategies or else risk failing to reach their objectives.

Currency risk is often viewed as a by-product of the broader investment strategies that an investor has employed, rather than an asset class in its own right. As such, it can be overlooked in multi-asset portfolios.

In a low-return environment, there are four strategies that may be employed to manage currency risk and help to make the most of the return opportunities from currency:

1) Reduce unrewarded risk with static currency hedging
2) Manage currency risk smartly with dynamic currency hedging
3) Seek additional returns with currency factor strategies
4) Employ cost-efficient implementation

In today’s blog, we’ll look at the first two strategies on the list: static currency hedging and dynamic currency hedging.

1) Potentially reducing unrewarded risk with static currency hedging

Unrewarded risk

If a portfolio contains unhedged international assets, then an exchange risk is being automatically taken without being paid, i.e., unrewarded risk. This currency exposure is only a by-product of the asset exposures, not a clearly articulated currency investment strategy from which you expect to earn returns. For example, a typical global equity portfolio (from a U.S. investor perspective)¹ implicitly holds a long position in a basket of currencies consisting of roughly:

We believe currency hedging using foreign exchange forward contracts is a useful way to reduce unrewarded risk. By selling an appropriate amount of foreign currencies forward, hedging creates positions that move in the opposite direction to the currency exposures in the underlying portfolio. Currency hedging can be performed in two different ways: statically or dynamically.