Managing Currency Risk for the U.S. Investor

As we progress into 2012, the spotlight continues to shine brightly on the foreign exchange market with the focus centered on Europe’s ongoing sovereign debt crisis and its impact on the euro.

This is an opportune time to review the fundamentals of the foreign exchange market (a.k.a. the currency market) and create an appropriate investment strategy for managing one’s currency risk within their portfolio.

Overview of the Currency Markets

If asked to name the world’s largest and most liquid market, many may be surprised to hear the answer is the currency market. This is especially impressive considering there is no centralized exchange for trading currencies. Fundamentally, however, it is rational that such a globalized world requires an accessible transfer of currency to be able to transact beyond borders.

The average daily currency turnover is currently $4 trillion, compared with $3.3 trillion in 2007, indicating an ever increasing market and global economy. However, the market is still heavily weighted within particular geographical areas, as 37% of all currency market trading takes place in the UK and 18% in the United States. The U.S. dollar is the most highly traded currency at 43% of the market compared to 20% for the euro. As the world continues to become more interconnected and emerging economies grow, the currency markets may experience considerable changes.

Currency markets are extremely sensitive to world events and are viewed as the most reliable market to accurately reflect global economic and political changes. Currencies are generally fairly valued over the long term, but like equity or fixed income investments, there are times when a combination of economic, political, and psychological factors causes some currencies to be over- or under-valued relative to others. Being such a liquid market, impacts of significant events can be seen within currency trading almost immediately.

Currency Effects on a Portfolio

Investments in international securities can generate positive returns and add a greater degree of portfolio diversification, but the underlying exchange rates introduce an added risk. Since foreign exchange rates can have a significant impact on portfolio returns, investors should be mindful of their portfolio’s exposure. Studies show that over time the expected return from unmanaged currency exposures is zero, even despite an increase in risk. 

International investments can either be hedged or unhedged to the foreign currency. If unhedged, the investor has full currency exposure and their portfolio value will fluctuate based on the changes of the foreign currency relative to their domestic currency. These unhedged currency effects can therefore, help or hurt the returns of the underlying investments, and tend to provide incremental volatility without additional long-term return. 

On the other hand, investments can be hedged against currency risk, either with a passive or an active approach. Passive hedging is achieved by maintaining a fixed currency hedge percentage in the investment. For example, if a U.S. investor is hedged 100%, their investment will always be denominated in U.S. dollars and will not realize the positive or negative effects of an appreciation or depreciation of the foreign currency. Although less volatile than an unhedged investment, passive hedging tends to be more volatile than active hedging. Active hedging is achieved by allowing the investment portfolio’s currency exposure to fluctuate based on the market environment, usually within a specified range. This gives the investment manager the discretion to change the level of the hedge when they see opportunities or risks.  

Investment managers typically base their investment decisions primarily on the strengths of individual companies that meet the objectives of their defined strategy, but they will often adjust the related currency exposures based on the fundamentals and outlook of the foreign exchange market. The recent S&P downgrades of nine euro-zone countries and the turmoil associated with the euro is a prime example of why hedging international investments is a timely and significant issue. Of course, hedging necessarily also limits potential upside to currency exposure, and there are added transaction costs to execute the hedge that may also hold down returns. From 2002-2010, for example, when most foreign currencies appreciated relative to the U.S. dollar, an unhedged foreign security portfolio would have outperformed an equivalent hedged portfolio. The value of the hedge is in reducing return volatility during these changing periods with the right strategy in place to mitigate the risks while seeking to take advantage of opportunities when they arise.

Conclusion

The currency market is the engine of the global economy. It is massive, complex, self-regulating, and a major driver in country development and world trade. Because currency markets change rapidly based on the world’s economic environment, it is very important to have the proper currency management strategy in place. Hedging foreign currency exposure for U.S.-based investors typically reduces volatility, and can be executed with a passive or active strategy. Hedging is ultimately a strategic decision based on an optimization of investment risk and return. Since currency markets are so cyclical in nature, currency movements give investors an opportunity to consider the timing of initiating a hedging program on a tactical basis. You should confer with your investment consultant or your portfolio managers to determine which type of strategy they utilize and make certain that strategy is most appropriate for you.