Let’s start at the beginning: what is currency hedging (CH)?
If we just go straight for the basics then it is a situation where investors
have assets in countries where they are not resident and so use CH to try and
protect themselves from any fluctuations (especially sudden ones) in the foreign
currencies and how they will affect the money invested when it is valued in the
home currency of the investor. These changes in the different value of
currencies can be caused by various things such as economic fundamentals et al.
CH should limit the effect of any wild shifts in exchange rate valuations.
The benefits of hedging are very much reliant of the aims of
the investor and the currencies being hedged.
Working out the cost of hedging is also very important. If any potential hedging
is only a small part of a portfolio then the costs of setting up the hedge may
well not be worth it. Costs include payments to currency dealers, banks and
investment managers. These costs are for such things as:
- Bid/Offer spreads
- Rebalancing the actual hedge back to within the acceptable parameters
- Liquidity in a particular currency
- Offsetting risk, i.e. such things as a default, etc.
The next question is if there is such a thing as the perfect hedge ratio? As
with almost everything in the economic world there are a number of varying
opinions on this one. They range from people saying that no hedge is best to
others saying that a portfolio can only achieve optimal performance if there is
a total hedge. What it basically comes down to, though, is the investor’s
risk/reward ratio and over what time period any portfolio is going for. One
other thing that is vital is for the investment to be monitored regularly. If
everything with the hedge works well then the investor will be guarded against
inflation, market volatility (especially commodities), changes in interest
rates, and forex fluctuations. That is all the good news. The downside of
hedging means that people may not be as liquid as they would wish to be. It must
also be remembered that the idea of a hedge is to minimize risk, therefore, by
nature this will potentially reduce gains.
Fig.1
As a simple example, let’s look at what happens when you
compare the US Dollar against the British Pound in the marketplace. So, should a
Sterling-based investor have the same global equity exposure as a US
Dollar-based investor?
As most people know, the American US equity market makes up nearly 50% of global
equity whereas the British one is only around 10%. This obviously shows that
there is less need for an American to hedge than a Brit. But what about the
levels of volatility, are they the same and can worldwide access give a better
rate of return? If you look at figures 1 and 2 you can see that, apart from a
couple of short term differences, the volatility for both American and British
investors with access to world markets is roughly the same.
However, where things do start to differ are on a one or five year interval as
these can show large differences in the rates of return. Figures 4 and 5 show
this as these charts show hedged being USD returns and un-hedged are in GBP
terms.
It is noticeable that at the height of the crisis in 2008, the Morgan Stanley
Capital Index (MSCI) World Annual rolling returns were down only 25% in GBP
terms as opposed to minus 50% in US Dollars. This was mostly due to how weak the
British pound was five years ago. The five year chart indicates exactly how
returns can vary on a large scale, i.e. the five year period ending in 1985
shows a GBP return of 160% as against only 60% in US Dollars.
Fig.2
So what does all of this indicate? Well, an investor needs to
know what his/her risk/reward ratio is and the length of time that the
investment is needed as it is obvious that any swings over longer periods of
time even themselves out. However, on the downside, they can distort monthly
returns significantly. Hedging definitely has its place in the market and can
protect an investor dramatically. However, it can also cause chaos in the wrong
hands. Caveat emptor!
Fig.3
Fig.4
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The above data and research was compiled from sources
believed to be reliable. However, neither MBMG International Ltd nor its
officers can accept any liability for any errors or omissions in the
above article nor bear any responsibility for any losses achieved as a
result of any actions taken or not taken as a consequence of reading the
above article. For more information please contact Graham Macdonald on
[email protected] |
