Reasons Currency Hedging Matters

May 22, 2015

Identifying The Risks

The table below summarizes a quick calculation of return/risk, and highlights the differences between hedged and unhedged portfolios. In every case, the return/risk ratio of the hedged portfolio is higher. So over the long run, it seems that dollar-based investors that hedge will have more efficient portfolios. But the long run here is a long time. Do we reach a different conclusion if we shorten the time frame?


Full Period (12/31/94 - 4/30/15)
Return/Risk Ratio Hedged Unhedged Efficiency Difference
Hedged-Unhedged
USA 0.65 0.65 0
Europe 0.54 0.46 0.08
Japan 0.09 0.04 0.05
Latin America 0.65 0.31 0.34
Pacific ex-Japan 0.45 0.35 0.1
Emerging Europe 0.58 0.27 0.31
EAFE 0.41 0.35 0.06
Emerging Markets 0.5 0.27 0.22
ACWI 0.55 0.49 0.07



Timing Matters

The table below shows the return differentials of hedged and unhedged investors over two time frames. First, we look at a 7-1/2-year period of a strengthening euro, and then a 6-1/2-year period of a declining euro.


Increasing Euro (11/30/00-6/30/08) Decreasing Euro (6/30/08-4/30/15)
Annualized Returns Hedged Unhedged % Difference
Hedged-Unhedged
Hedged Unhedged % Difference
Hedged-Unhedged
USA 0.34% 0.34% 0.00% 9.79% 9.79% 0.00%
Europe 0.30% 7.17% -6.87% 6.74% 2.80% 3.94%
Japan 0.79% 1.18% -0.39% 4.56% 2.72% 1.84%
Latin America 25.48% 27.25% -1.77% 2.10% -5.05% 7.15%
Pacific ex-Japan 9.14% 15.62% -6.48% 6.84% 5.09% 1.75%
Emerging Europe 20.81% 23.19% -2.38% -1.62% -8.19% 6.57%
EAFE 1.02% 6.38% -5.37% 5.95% 2.99% 2.95%
Emerging Markets 16.85% 18.69% -1.83% 5.46% 2.20% 3.26%
ACWI 1.81% 4.27% -2.46% 7.37% 5.86% 1.51%

We have purposefully picked time frames very close to the trough and peak of the euro, as to better understand what the worst-case scenario is for someone who gets their timing wrong.

As we can see, if you get the currency direction wrong, it can have significant effect on the returns. A Europe investor who is hedged, while the euro is going from essentially 0.9 to 1.60, loses almost all of their return (0.30 percent versus 7.17 percent). On the other hand, a European investor who is hedged while the euro goes from 1.6 to 1.1, adds 3.94 percent per year in returns.

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