If I invest in securities denominated in a foreign currency, should I hedge my currency risk?

Question

If I live in the US and most of my expenses are in US Dollars, I consider the US dollar to be my base currency and look at the performance of my portfolio on a US Dollar basis.

If I invest in a fund or stock that is denominated in a foreign currency, should I hedge the position back to US Dollars?

If I do hedge, the performance of the investment will be reduced by the cost of the hedge. If I do not, the performance of the investment will reflection a combination of the performance of the stock or fund and the performance of the foreign currency against the US Dollar.

Should I hedge the investment or not?

Answer 1

Like most other investment decisions - it depends.

Specifically in this case it depends upon your view of the FX (Foreign Exchange) market over the next few years, and how sensitive you are to losses.

As you correctly note, a hedge has a cost, so it detracts from your overall return.

But given that you need to repatriate the investment eventually to US Dollars, you need to be aware of the fluctuations of the dollar versus other currencies.

If you believe that over your time horizon, the US dollar will be worth the same as now or less, then you should not buy the hedge. If the dollar is the same - the choice is/was obvious. If you believe the US dollar will be weaker in the future, that means that when you repatriate back to US dollars, you will purchase more dollars with your foreign currency.

If on the other hand, you believe the US Dollar will get stronger, then you should certainly lock in some kind of hedge. That way, when your foreign currency would have effectively bought fewer US, you will have made money on the hedge to make up the difference.

If you choose not to hedge now, you can likely hedge that exposure at any time in the future, separate from the initial investment purchase buy buying/selling the appropriate FX instrument.

Good Luck

Answer 2

No. This is too much for most individuals, even some small to medium businesses.

When you sell that investment, and take the cheque into the foreign bank and wire it back to the USA in US dollars, you will definitely obtain the final value of the investment, converted to US$. Thats what you wanted, right? You'll get that.

If you also hedge, unless you have a situation where it is a perfect hedge, then you are gambling on what the currencies will do.

A perfect hedge is unusual for what most individuals are involved in. It looks something like this: you know ForeignCorp is going to pay you 10 million quatloos on Dec 31. So you go to a bank (probably a foreign bank, I've found they have lower limits for this kind of transaction and more customizable than what you might create trading futures contracts), and tell them, "I have this contract for a 10 million quatloo receivable on Dec 31, I'd like to arrange a FX forward contract and lock in a rate for this in US$/quatloo." They may have a credit check or a deposit for such an arrangement, because as the rates change either the bank will owe you money or you will owe the bank money. If they quote you 0.05 US$/quatloo, then you know that when you hand the cheque over to the bank your contract payment will be worth US$500,000. The forward rate may differ from the current rate, thats how the bank accounts for risk and includes a profit.

Even with a perfect hedge, you should be able to see the potential for trouble. If the bank doesnt quite trust you, and hey, banks arent known for trust, then as the quatloo strengthens relative to the US$, they may suspect that you will walk away from the deal. This risk can be reduced by including terms in the contract requiring you to pay the bank some quatloos as that happens. If the quatloo falls you would get this money credited back to your account. This is also how futures contracts work; there it is called "mark to market accounting". Trouble lurks here. Some people, seeing how they are down money on the hedge, cancel it. It is a classic mistake because it undoes the protection that one was trying to achieve. Often the rate will move back, and the hedger is left with less money than they would have had doing nothing, even though they bought a perfect hedge.

Answer 3

As the other answer already states, whether you should or shouldn't currency-hedge your equity investments depends on a lot of factors.

If you decide to do so, depending on your investment vehicles, there might be a more cost-efficient way than arranging a separate futures contract with a bank:

If you are open to (or are already investing in) ETFs, there are currency-hedged versions of some popular ETFs. These are hedged against the currency risk for a specific currency; for example, if you are buying in (and expecting to sell for) USD, you would buy an ETF hedged to USD.

Of course they have a higher expense ratio than non-hedged ETFs since the costs of the necessary contracts are included in the expenses.

Answer 4

So far we have a case for yes and no. I believe the correct answer is... maybe.

You mention that most of your expenses are in dollars which is definitely correct, but there is an important complication that I will try to simplify greatly here. Many of the goods you buy are priced on the international market (a good example is oil) or are made from combinations of these goods. When the dollar is strong the price of oil is low but when the dollar is weak the price of oil is high. However, when you buy stuff like services (think a back massage) then you pay the person in dollars and the person you are paying just wants dollars so the strength of the dollar doesn't really matter.

Most people's expenses are a mix of things that are priced internationally and locally with a bias toward local expenses. If they also have a mix of investments some of which are international and depend on the strength of the dollar and some are domestic and do not, then they don't have to worry much about the strength/weakness of the dollar later when they sell their investments and buy what they want. If the dollar is weak than the international goods will be more expensive, but at the same time international part of their portfolio will be worth more.

If you plan on retiring in a different country or have 100% of your investments in emerging market stocks than it is worth thinking about either currency hedging or changing your investment mix. However, for many people a good mix of domestic and international investments covers much of the risk that their currency will weaken while offering the benefits of diversification. The best part is you don't need to guess if the dollar will get stronger or weaker.

tl;dr: If you want your portfolio to not depend on currency moves then hedge. If you want your retirement to not depend on currency moves then have a good mix of local and unhedged international investments.