Exchange rate fluctuations are not only a source of annoyance in politics. Investors are also annoyed when foreign currencies lose value. Anyone who wants to successfully manage the currency risk in an international portfolio needs the right know-how – and a touch of tact.
Living in a counties that has powerful currency that tends to appreciate in value abroad is a fine thing. At least as a consumer. Imported goods from other countries become cheaper. And the cost of holidays abroad also continues to decrease the stronger the home currency becomes. For a consumer it is almost like being in a land of milk and honey: Purchasing power abroad is growing without having to pay anything.
The other side of the coin, however, is less positive. Because most consumers are also capital investors. And from this perspective, the world does not look quite so rosy: Those who invest abroad lose returns if their home currency rises or the foreign currency falls. With an exchange rate hedge, the problem should be resolved, one would think. But the solution is not that simple. Rather, managing currency risk properly is possibly one of the most complex problems in optimizing a portfolio. Because there are only a few generally applicable rules or principles of conduct.
MORE SECURITY, LESS RETURN
The art of optimal exchange rate hedging is like a difficult balancing act. In some cases it is actually possible to use hedges to significantly reduce the risk of a foreign investment while at the same time achieving higher profits. However, the price for more security is often a lower return. Then it ultimately depends on the investor’s risk appetite and investment goals whether hedging is the right decision. The choice is often not difficult. Because in some cases, strong fluctuations in value can be dampened considerably with comparatively low discounts in performance. The market constellation is of course ideal for an investor if not using hedging is the optimal strategy. That also happens – and not too rarely.
FLUCTUATIONS IN EXCHANGE RATES INCREASE THE OVERALL RISK
Exchange rate fluctuations contribute between 16 and 40 percent to the overall risk of equity investments abroad. In the case of government bonds it is even up to 95 percent. The risk is usually measured using what is known as volatility . It indicates how much the return on an investment fluctuates around its mean.
THE CURRENCY RISK CANNOT BE DIVERSIFIED AWAY
What sounds plausible in theory, however, turns out to be a tough nut to crack in practice. The currency risk cannot simply be diversified away by holding different currency positions in the portfolio. This is shown by model calculations that compare internationally mixed equity portfolios with portfolios that only invest in one foreign equity market. The mixed portfolios contain different currency positions, the comparison portfolios only one.
Result: With exchange rate hedges, the volatility in the multi-country accounts can be reduced to a similar extent as in the accounts with only one foreign currency.
EXCHANGE RATE HEDGING COSTS MONEY
But such safeguards naturally cost money. They are only worthwhile if exchange rate losses ultimately exceed the hedging costs. It sounds straightforward and simple at first – but it isn’t. Because not only exchange rates are hardly predictable. The level of protection costs also fluctuates over time and is difficult to predict. In addition, these costs consist of three components: transaction costs, interest payments (in some cases investors also earn interest income) and lost profits (opportunity costs). The latter result from the hedge itself, because the investor does not participate in currency appreciations. The level of the opportunity cost, in turn – and now it gets even more complicated – depends on the relationship between the actual investment and the exchange rate. If both prices move in the same direction over time, economists speak of a positive correlation, a statistical measure that can be used to describe the relationship between two asset classes. If one price goes down when the other goes up, the correlation is negative. There is no correlation if no directional relationship can be measured and both courses fluctuate independently of one another.
IN EMERGING MARKETS IT IS HARDLY WORTHWHILE TO HEDGE THE CURRENCY RISK
It is generally not advisable to hedge against currency risk when buying securities in emerging markets. The reason is the high costs due to high local interest rates. For example, an American who wanted to hedge a plant in Brazil in 2010 had to pay 6.4 percent for it by the end of November – not counting lost currency gains (opportunity costs). 10-year Brazilian government bonds in local currency had a yield of 12.45 percent at the time. More than half of this would be consumed by insurance costs. Protection of the exchange rate is not advisable in the event of such disparities. As a matter of theory, for emerged markets and commodity currencies such as Australian and Canadian dollars, the following rule of thumb applies: they are high if the world economy expands well and faith is improved in foreign capitals. When on the other hand, at the height of the financial crisis in 2008, uncertainty or even hysteria breaks up in the stock markets, such monetary crashes with another stock market as investors exit. Foreign currencies that are viewed as a safe haven, such as the Swiss franc and the US dollar, are then in demand.
GOVERNMENT BONDS SHOULD GENERALLY PROTECT INVESTORS
For government bonds from industrialized countries with good credit ratings, exchange rate hedging is clearly the first choice. Anyone who invests in such fixed-interest securities wants to achieve a largely secure return with them and put the entire portfolio on a solid basis. But in times of rising national debt in many developed countries, international diversification of the bond portfolio is becoming increasingly important. Foreign government bonds, however, harbor a considerable exchange rate risk because these supposedly safe investments can turn into risky currency speculation. Research shows that 95 percent of fluctuations in the yield on foreign currency bonds result from the high volatility of exchange rates. This is why the advantages of hedging clearly outweigh the disadvantages in this asset class: The volatility of foreign government bonds is falling significantly. The toll for this is slightly lower returns due to the cost of currency hedging.