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Is Currency Hedging Worth the Cost?

Hedging costs, currency movements, and the characteristics of underlying assets, are among the many factors to consider in deciding whether to hedge FX risk.

For euro-based investors wishing to hedge U.S. dollar assets, the return drag from hedging has risen from 0% at the beginning of 2014 to over 2.5% today.

As Figure 1 shows, this has been driven by both diverging short-term interest rates in the U.S. and the eurozone, and a persistently negative currency (FX) basis. The former reflects the different stages in the monetary policy cycles of the European Central Bank and the Federal Reserve, while the latter has been primarily the result of strong net demand for U.S. dollar funding, globally.

Although investors have faced similar hedging costs in the past, an important difference is the starting level of yields: 2.5% hedging drag when 10-year U.S. Treasuries yield less than 3% is far harder to cope with than when they yielded more than 4%, which was the case in previous periods of high hedging costs.

Does this mean investors should stop hedging currency risk in their bond portfolios?

We don’t think so. To understand why, it is important to consider the impact of hedging on risk as well as return. Comparing unhedged and hedged U.S. Treasury investments since the launch of the euro (shown in Figure 2) highlights two key points:

  1. Leaving high-quality bond allocations unhedged materially increases risk relative to a currency hedged investment. Although a euro-based investor would have improved cumulative returns by not hedging currency exposure, the much higher volatility – driven by currency risk – would have halved risk-adjusted returns, as represented by the Sharpe ratio.
  2. Although saving over 2.5% per year in hedging costs may sound appealing, these savings can be easily wiped out by currency volatility. Looking at the long run, the U.S. dollar has depreciated more than 2.5% versus the euro almost half of the time, on a one-year rolling basis. This risk has been even more evident in the last 12 months, when the U.S. dollar lost more than 13% of its value1.
 

The above example refers to the most common high-quality asset (i.e. U.S. Treasuries) but whether or not to hedge currency risk will ultimately depend on many factors, including the volatility and the credit risk of the asset being hedged, whether the decision is made at the asset class or portfolio level, and the specific objectives of the investor. However this highlights that a focus on hedging cost alone could lead to sub-optimal investment outcomes.

For further details, including analysis of higher volatility bonds and partial hedging, read “The FX Dilemma: An Introduction to Hedging Currency Risk in Bond Portfolios”.

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1 U.S. dollar value measured against the euro. Reference period: 28 February 2017 to 28 February 2018. Source: Bloomberg.
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Giacomo Bonetti

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Past performance is not a guarantee or a reliable indicator of future results.

FORECAST: Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.

HYPOTHETICAL EXAMPLE: No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product, or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market risks such as lack of liquidity. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results.

ESTIMATED VOLATILITY: We employed a block bootstrap methodology to estimate volatilities. We start by computing historical factor returns that underlie each asset class proxy from January 1999 through the present date. We then draw a set of 12 monthly returns within the dataset to come up with an annual return number. This process is repeated 25,000 times to have a return series with 25,000 annualized returns. The standard deviation of these annual returns is used to model the volatility for each factor. We then use the same return series for each factor to compute covariance between factors. Finally, volatility of each asset class proxy is calculated as the sum of variances and covariance of factors that underlie that particular proxy. For each asset class, index, or strategy proxy, we will look at either a point in time estimate or historical average of factor exposures in order to determine the total volatility.

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