How does currency hedging work?
Currency hedging in investment portfolios typically uses FX forward contracts – agreements to exchange a set amount of one currency for another at a predetermined rate on a future date. The contracts are rebalanced at regular intervals, ensuring that the value of the hedge remains aligned with the underlying investment exposure.
The performance of a hedged investment is influenced by hedging costs, primarily inte
rest rate differentials as well as trading costs, hedge ratio, investment ratio and any lag in reinvesting proceeds. Currency-hedged ETFs automate the hedging process for investors, offering a transparent and cost-effective solution.
The key driver of the hedging cost or benefit is interest rate differentials (“cost of carry”), i.e., the difference between the interest rates of the two currencies involved in the hedge. The higher the interest rate differential between two currencies, the greater the cost (or benefit) of hedging to the investor. Hedging from a lower-yielding to a higher-yielding currency (currently, JPY to USD) results in positive carry and boosts returns, while hedging from a higher-yielding to a lower-yielding currency (currently, GBP to CHF) leads to negative carry, reducing performance.
Other factors include transaction costs for the foreign exchange (FX) forward where market spreads are incurred on both the near and far leg of the FX forward contract. As a rule of thumb: the more illiquid the currency pair, the higher the cost of hedging. While the target hedge ratio is 100% and regularly rebalanced, it may fluctuate between adjustments due to movements in the underlying exposure, resulting in periods of over- or underhedging and their associated costs or benefits.
Similarly, the investment ratio, which measures the value of the underlying exposure relative to total assets, including any FX profit & loss (P&L), is aimed at 100% and regularly readjusted. Movements in FX P&L can cause temporary under- or over-investment with the corresponding positive or negative impact.
