Currency Risk in an International Portfolio: Hedged or Not

It arrives as a by-product of owning foreign assets. The only decision available is whether to leave it or pay to reduce it, and both answers are defensible. This article explains the mechanics, what hedging costs, and why the choice depends on facts about the reader rather than facts about currencies.

Where the exposure comes from, and how big it is

If you hold an asset denominated in another currency, your return has two components. The asset's return in its own currency, and the movement of that currency against yours. They combine multiplicatively rather than additively — a 10% asset gain with a 10% currency loss leaves you at 0.99 of where you started, not exactly level — and either can dominate. A US-based holder of a Meridian equity fund can see Meridian shares rise 12% and still lose money if the mark falls 15%. Three things to notice about this exposure. It is usually invisible. A fund reports a single return figure in your currency, so the asset and currency components are already blended and you cannot tell which produced the outcome without decomposing it deliberately. It is often large relative to expectations. Currency movements of 10–20% a year against a major counterpart are unremarkable, which is a substantial fraction of what most people expect an equity portfolio to earn. And the fund wrapper does not remove it. A fund priced in dollars that holds Meridian shares still carries mark exposure — the pricing currency of a fund tells you nothing about the currency exposure of its holdings, and confusing the two is the commonest error in this area. Where the exposure matters most is a question of asset class. For international bonds, currency movement typically swamps the return: a bond yielding 4% carries currency swings several times that, so an unhedged foreign bond holding is substantially a currency position wearing a bond's clothing. For international equities, currency is a smaller share of a larger and more volatile return, and there is a longstanding argument that currency exposure is partially self-offsetting in a diversified global equity portfolio because different currencies move differently. That argument is contested rather than settled, and this portal reports it as such. The asset-class distinction, however, is widely accepted and is the most useful thing in this article: the case for hedging international bonds is considerably stronger than for international equities, and it rests on the ratio of currency volatility to expected return rather than on any view about exchange rates.

What hedging is, what it costs, and why the answer is personal

Hedging currency exposure means holding an offsetting currency position, most commonly through forward contracts whose mechanics Pillar 17 established — a fund manager sells the foreign currency forward in the amount of the holding, so a fall in that currency produces a gain on the forward that offsets the loss on the asset. The mechanics are unremarkable. The costs are where the substance lies, and there are four. The forward is priced off the interest-rate differential, per the covered interest-rate parity relationship — which means hedging a currency whose rates are lower than yours produces a positive carry and hedging one with higher rates costs you. This is the point most often misunderstood: hedging is not inherently expensive or cheap, and its cost or benefit changes with rate differentials rather than being a fixed fee. A hedge that paid you last year can cost you this year with nothing else changed. There are operational costs — the transaction cost of rolling forwards continuously, typically embedded in a hedged share class's expense ratio as a small increment. Hedges are imperfect. They are struck on a notional amount that drifts as the underlying asset moves, so the hedge is periodically over- or under-sized between rebalancings, and that residual is real. And hedging removes gains as well as losses. This is not a cost in the accounting sense but it is the substantive trade: a hedged holder who would have benefited from a favourable currency move does not. Now the decision, and this portal will not make it. What it can do is name the facts the decision turns on, all of which are about the reader rather than about currencies. Horizon: currency effects are large over years and have historically been a smaller share of very long-run returns, so a thirty-year horizon and a three-year horizon are different problems. The currency of your liabilities: someone who will spend in dollars has a different problem from someone planning to retire abroad — the relevant question is not "which currency will strengthen" but "what currency will I spend in", and that reframing is the most useful thing a reader can take from this pillar. Asset class, per the distinction above. Volatility tolerance: hedging reduces the volatility of a foreign holding measured in your currency, which has real value to someone who would otherwise sell at a bad moment. And cost sensitivity, since the hedge's carry can be positive or negative and its operational cost is certain. Both answers are defensible and neither is default-correct. A reader who hedges everything is accepting a certain cost to remove an uncertain exposure; a reader who hedges nothing is accepting an uncompensated risk in exchange for avoiding that cost. What is not defensible is holding significant foreign exposure without knowing it is there.