Should Currency Risk be Hedged?

Should Currency Risk be Hedged?

Generally, unmanaged currency risk in an internationally invested portfolio is a source of uncompensated volatility.  For that reason, Overlay Asset Management advises investors to considered hedging foreign currency exposures.

Currency fluctuation accounts for a significant portion of portfolio risk.  (as a rule of thumb, roughly 75% of an international developed markets bond portfolio’s volatility can be attributed to currency risk, and roughly 25% of an international developed markets equity portfolio’s volatility can be attributed to currency risk.)

Over the long term (5-10 years), the expected return to foreign currency may be zero, but its contribution to total portfolio volatility can be significant.

Over shorter periods, currency movements can be significant.  The change in exchange rates may work in favour or against an investor.  But over the long run, even positive return contributions are often outweighed by significant increases in overall portfolio volatility, resulting in lower portfolio information ratios and sharpe ratios.

Since mid-2007, currency markets have become more volatile.  Generally, the risk contribution from unhedged currency exposures in an internationally invested portfolio will be higher than they have been in the past.  For this reason, currency risk management may be more of a priority than ever.

Where a separate currency hedging program is implemented, equity or fixed income managers, for example, are held responsible for investment decisions within their area of expertise, and a specialist currency manager is held responsible for currency allocation decisions.

The source of returns, whether they are generated from the underlying asset classes or from currency positions, also becomes much more transparent to the end investor.

For more information on Overlay Asset Management’s currency hedging solutions, please contact us.