Hedging is a valuable strategy to mitigate currency fluctuations’ effect on investment results and should be carefully considered when investing internationally.
The University utilizes currency risk hedging strategies to mitigate departmental budgets and related cash flows from becoming too volatile. When implemented effectively, these hedging strategies can provide many advantages, including:
Risk Management
Investment opportunities abroad may present themselves, yet currency movements can create risks which might reduce expected returns. Hedging can reduce this risk.
An European company selling its products in the US could protect itself by purchasing a forward currency contract to sell Euros and buy USD at a predetermined rate, thereby protecting itself from losses while offering opportunities should market conditions shift in their favour.
Forex trading markets can be very messy, and to be successful in hedging the trades, it requires an expertise most small business owners lack. Such dynamically hedged ETFs can offer help through the rules-driven mechanisms and algorithms that automatically hedge or not in response to the market environment to lower volatility and keep expenses under control.
Predictability
As globalization brings companies that sell in multiple countries closer together, companies that sell must convert sales into local currencies so as to pay suppliers on time and avoid losses due to sudden shifts in exchange rate prices. Hedging currency risk is the way for such organizations to avoid potential financial setbacks incurred from unfavorable changes.
Hedging can provide investors with an advantage in rising currency, as costs associated with their hedge will decrease and profit can be realized. Hedging is therefore an attractive choice for international investing.
Determining the right time and amount to hedge can be challenging, yet dynamically hedged ETFs provide investors with an automated solution using rules-based processes and proprietary signal overlays that automatically adjust currency exposure up or down according to specific signals. This enables them to both take advantage of rising currencies while mitigating risks that changing currencies could significantly lower returns – the historical risk reduction results from full currency hedging on developed-market equity ex-US portfolios are impressive (see Exhibit 1).
Reliability
Hedging strategies provide investors with exposure to foreign markets with an effective means to protect their returns from currency movements, including locking in an exchange rate for converting international funds back into their home currency.
Hedging instruments such as forward contracts and options that enable users to prearrange an exchange rate can help mitigate this risk by making variable costs into fixed ones, creating more predictable budgets and forecasts while being less susceptible to sudden market shifts.
Hedging can help minimize portfolio volatility by offsetting gains or losses caused by foreign currency fluctuations. Dimensional recently published a study which concluded that full currency hedging reduced maximum drawdowns of global bond ex-U.S. portfolios by $15 million and developed-market equity ex-U.S. portfolios by 7 million respectively.
Flexibility
Hedging strategies offer more than just protection; they can actually allow businesses to profit from currency movements. For example, an US-based business that sells to customers in Europe could use “leading and lagging” hedging techniques by delaying payments to suppliers until the exchange rate favours their company.
Hedging can also help companies better anticipate and budget for inflows and outflows, providing more accurate planning of growth plans, while offering managers the chance to align corporate objectives with market conditions.
Hedged funds use financial derivatives to reduce the impact of global currency fluctuations, providing investors with reduced volatility and higher Sharpe ratios than unhedged portfolios. But an effective hedge requires striking a delicate balance between risk and return; so before committing to any strategy it is vital that investors carefully consider exposure levels, risk tolerance levels, hedging costs, available instruments and time horizons before selecting an optimal mix of techniques that suit their particular circumstances.