Currency |
September 24Why should an Investor deploy Currency Hedging Strategy
The world wide integration of the financial
markets no doubt has lead to diversification of business and significant return
on international investments. The potential of high yield is enticing, but it
also brings with it potential risk which is the by-product of dependency on foreign
currency. The dollar is going strong in comparison to other currencies, which
is beneficial for US visitors, but not for the investors. The conundrum of
hedging or not hedging of the currency continues to give sleepless nights to
the investors.
If we consider the underlying economics of
currency exchange, if a foreign investor invests in dollar, he will get return
in local currency; if it is converted in US dollar it will not have much return
when the dollar is strong. A weak dollar will boost international returns. If
we observe the dollar currency performance in the chart below, it clearly shows
US economy is growing and leading other developed economies. It has led to high-interest
rates, difference in income for dollar investors and escalating trade tensions
in developing nations. All these factors have furthered strengthened the US
dollar
Now the question arises, is
it prudent and frugal to invest without hedging considering the international
exposure and strengthening of the dollar?
Pros
of Currency Hedging
- Restricting
the Fluctuations: The exchange rate
fluctuations can result in risk or reward on the cross border currency
investments. With the rising dollar, the Non-US investors are not in a
rewarding position, but with the hedging of currencies, one can manage or limit
the fluctuations. The higher return on investment by reducing risk will help
the investor in investing liberally as the peer comparison will be improvised
and have a positive impact on portfolio performance.
- Mitigating
the risk on international investment: Converting
the currency may result in a drop in net returns that goes in your pocket. Currency hedging can minimise that risk
as it insulates the investment from the currency fluctuations leading to loss.
How does it mitigate the damage? By providing a pay-off which primarily is
based on rising and fall in dollar. E.g. the pound is weak due to the decision
of the United Kingdom to leave the European Union with or without any deal, but
the equity market is still growing. Why is that? It is because their hedged
investments outscored by 6.5% point in comparison to unhedged investments.
- Defined
benefit pension fund: If an investor can make the
efficient use of risk by managing the currency exposures, it can help in
achieving a level in funding. A Defined benefit pension fund matches the
liabilities and assets of the investor and currency investments are a liability
that can be matched with the hedging of the currency. The cost of levelling the
mismatching by hedging is relatively less than the gains of asset allocation.
Cons
of Currency Hedging
- Letting
go of perks CCR: When the Currency Conversion Rates are not favourable, currency hedging
will reduce the risk and loss. On the contrary, when the rates are in your
favour, then you have to forego the bonus that could have been added in your
return.
- Impact
on Bonds over Equities: As the rate of returns is
fixed on bonds, a fluctuation in currency can significantly affect its return.
Whereas, equities are volatile in nature and won’t have any major effect if the
hedging is added. Bonds being stable in nature will become volatile with currency hedging. A point to note here
is that, if investment in foreign bonds is less than the cost of hedging,
then it will not be a good idea
- Hedging
Cost: Investors need to pay for covering the risk
on their foreign investment. It starts with the commission of investment
manager, then custodian bank that is doing record-keeping for you and of course
the currency dealers who are doing hedging for you. So, it is essential to
consider that is the investment worth the hedging?
The
Verdict
Hedging currencies is a smart move when the
dollar is strengthening, but at times unhedged currencies provide the benefit
of a diversified portfolio. It happens at the time of negative equity-FX
correlation. Therefore, before hedging the currencies, an investor should
scrutinise their portfolio and weigh out the impact of foreign investment on
it. If the investor has a gut feeling that unhedged currency will have positive
implications considering social-economic, geopolitical factors and market
fluctuation, then he can opt out of hedging or vice-versa.