The effectiveness of a currency hedge depends on factors such as interest-rate differentials, currency and interest-rate volatility and spot currency behavior under market stress. This forecasting challenge and the operational complexity of regular hedge adjustment means many investors settle for static hedges at 50%, 100% or staying completely unhedged (0%). The ultimate choice will affect risk and return on an absolute, relative and risk-adjusted basis.
For investors exposed to the same universe as the MSCI USA Index, the chart below shows how risk (measured by annualized volatility) varies by currency and hedge ratio. For example, the lowest volatility for CAD-based investors was with a near-0% hedge (unhedged) while JPY-based investors experienced the least total risk when fully hedged (100% ratio).
Investments denominated in GBP, or in risk-on currencies like AUD and CAD, had higher return volatility as hedge ratios increased, whereas investments based in JPY and CHF had a steady decline in risk as hedging increased. EUR showed a more neutral pattern: Volatility remained relatively stable across hedge levels.
Returns were a different story. The return differences include the hedging cost, something determined by the short-term interest-rate differential between home and target currency. During the analysis period, U.S. rates were generally higher than those in most other DM countries. This tended to make hedging more expensive for international investors. For JPY, for example, the hedging costs almost took up 50% of unhedged returns.
The trade-off between these two has sometimes been surprising. For JPY, hedging reduced currency return volatility, but also significantly reduced returns. That made an unhedged approach (0% hedge ratio) historically optimal for risk-adjusted returns.
