#16 FX Hedging: To hedge currency risk or not?
FX hedging, or hedging against currency risks, is a topic that is often discussed in the financial world. But how exactly does FX hedging work and should you hedge your portfolio against currency risks?
The basic principles of FX hedging
The basic idea behind FX hedging is simple: if you want to invest in US equities, for example, you exchange your home currency for US dollars and buy an ETF on the S&P 500. At the end of the investment period, you sell the ETF and exchange the US dollars back into your home currency. Sounds simple, right?
But here's the catch: the return in your home currency can be heavily influenced by currency fluctuations. If your home currency has appreciated against the US dollar in the meantime, the positive return in the local currency can be wiped out or even be negative.
Currency hedging for risk diversification
The solution is currency hedging or FX hedging. In the example above, the US dollars are not sold at the end of the investment period, but forward at the beginning, a so-called FX forward. This fixes the exchange rate and eliminates the currency risk.
But how good is this really? The US dollar yield curve is often higher than that of the Swiss franc. This means that when hedging against currency risks, the difference between the yield curves of the two currency areas must be taken into account.
The fund manager of a currency-hedged ETF regularly enters into forward exchange transactions by buying the home currency forward and selling the foreign currency. This is typically done every three months, creating small bid-ask spreads. Although these spreads are small for each transaction, they add up over the long term and have a negative impact on the portfolio's return.
Costs of currency hedging
So what does currency hedging cost? Firstly, it neutralizes the interest rate difference between the two currencies. Secondly, spreads are regularly incurred, which reduce the return. Thirdly, an investment instrument with currency hedging in Swiss francs is a niche product that is often associated with somewhat higher costs, as it was designed specifically for the Swiss market.
When does currency hedging make sense?
FX hedging is particularly useful if you want to invest in a very low-risk investment strategy and there are too few investment opportunities in your home currency. Currency hedging can also be advantageous if you expect a strong appreciation of your home currency.
Is it worth the additional cost to eliminate the currency risk? This is a decision that each investor must make individually, depending on their risk tolerance, investment strategy and market assessment.
What do you think about FX hedging? Write me an e-mail with your experiences.