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Thinking About Currency Risk: To Hedge or Not to Hedge

October 17, 2011 | About:
In my previous article I advanced the idea of investing globally and went over the major concerns that one faces in doing so. If you are inclined to give it a go (implying that you are already past the barriers of: lack of familiarity with foreign markets, political risk, market efficiency, regulations, transaction costs and taxes), here I would like to talk about currency risk — what it is, how to measure it and how to hedge it.

Let’s say you are a U.S. investor looking at European stocks (listed on European exchanges). Now that the European Union is in a big mess, there must be some unreasonably beaten-up stocks that were dragged down by the market turmoil.

Since you will be buying euro-denominated assets, you will first need to get euro. This is your currency risk. Eventually, when you liquidate your European assets, you will probably want your cash converted back to dollars, unless you move to Europe and spend your money there. As an investor you are concerned with the return on your assets. As a global investor you are concerned with that and the return on the foreign currencies you are holding.

How to Calculate Currency-Adjusted Returns

A common misconception is that adding up the return on investment in the local currency and the percentage change in the exchange rate equals the total dollar return in the domestic currency. This is very close but not quite it. The difference comes from the exchange rate effect on the capital gain which is omitted in the above calculation.

Here is the proper way to do it, followed by an illustration.

r$ = r + s + rs

This equation calculates the US dollar return, r$, by adding up the return on the investment in the local currency, r, the percentage change in the exchange rate, s, and the currency return that applies to the capital gain, rs.

Example:

Cost of investment (at time T)= €100

Market value of investment (at time T+1) = €120

Initial exchange rate (at time T)= $1.20 per €

Current exchange rate (at time T+1) = $1.50 per €

Return on investment in € (r) = (120-100)/100 = 20%

Percentage change in the exchange rate (s) = (1.50-1.20)/1.20 = 25%

Currency return on capital gain (rs) = 0.20 x 0.25 = 5%

Dollar return on investment (r$) = 20% + 25% + 5% = 50%

Check:

Cost of investment in dollars (at time T) = €100 x $1.20/€ = $120

Market value of investment in dollars (at time T+1) = €120 x $1.50/€ = $180

Dollar return on investment = (180-120)/120 = 50%

You gained 20% on the investment and another 25% on the Euro against the dollar, plus 25% on the 20% capital gain or 5% for a total of 50% total return (dividends were not paid in this period).

As you can see, the larger the capital gain and the bigger the exchange rate movement, the more important this last part of the calculation becomes.

Another thing to keep in mind is that for the equation to hold the exchange rate should be a direct quote, meaning domestic currency per unit of foreign currency, in our case US dollars per one Euro.

Now that you know how to correctly calculate your foreign returns, let’s see what causes exchange rates to move and where they might be headed.

What Drives Exchange Rates

The short answer is: too many things for a person to know. There are just too many moving pieces in the freely floating exchange rate system. Economists have advanced many theories explaining, and trying to forecast, exchange rate movements. They are no good for precise forecasts, but they do offer some framework for thinking about exchange rates.

Two major approaches are:

a) Purchasing power parity (PPP).

The simple idea behind PPP is that if you buy a basket of goods in the USA and sell it Germany, the USD/EUR exchange rate should be such that the Euro you got should convert to the dollar amount you paid for the basket. Put differently, movements in exchange rates should offset any differences in inflation rates between two countries.

Now, this is a useful simplification but its practical value is arbitrary. As I said, there are too many moving pieces for any remotely precise forecasting to work. Nevertheless, due to mean reversion, exchange rates do tend to move towards parity over the long term (5 years and more). Of course, even if they reach a point of balance, they don’t stay there.

So, at best PPP can give you some idea about where the exchange rate is headed in the very long term. If you happen to be a long-term investor, this may be good enough for you. The OECD provides a wonderful database of comparative price levels, PPPs and exchange rates.

b) Relative economic strength (RES).

While PPP focuses on trade flows (flows of goods and services), RES focuses on investment flows. The simple idea here is that a country with healthy economic growth and attractive investment opportunities will face a strong demand for its currency. Again, this is a general theory that can give you some idea as to the direction of future exchange rate movements over the very long term.

It’s rather logical that good economic and investment climate drive capital flows and currency appreciation. For the most part of the 20th century the USA was the poster child of RES in action. The investor can combine PPP with his views on RES to get a fuller picture.

But don’t let calculating currency-adjusted returns and thinking about purchasing power parities and relative economic strengths discourage you one bit. Read on to find out why you should stop worrying and love (global) investing.

Currency Risk – Not a Barrier to International Investing

Here are several good reasons why currency risk shouldn’t prevent you from investing abroad.

a) Currency risks are not additive.

Correlations among a large number of currencies tend to cancel out. Thus, if you set out to build a truly global portfolio with assets denominated in a whole bunch of currencies, currency risk shouldn’t be of much concern to you. As currency markets will have it, when one exchange rate goes up, another will go down and overall (and over time), for your basket of currencies, these movements will cancel out.

Studies have found that currencies move erratically to such an extent that they add only some 10% to the risk of investments in a diversified global portfolio as measured by standard deviation of returns (acknowledging that this is not the favorite measure of risk of value investors).

It goes without saying that currency risk should be measured for the whole portfolio rather than for individual securities or markets, otherwise you would be ignoring the diversification benefits of holding multiple currencies.

b) Currency risk is lower for long-term investors.

The contribution of currency risk to overall portfolio risk decreases with the length of the investment horizon. This conclusion is based on PPP and RES and at its core is mean reversion. As value investors, you are very familiar with the concept.

Basically, just as stocks do, exchange rates tend to revert to the fundamentally justified (based on PPP, RES or a similar framework of your choice) mean over the long run. Thus, you can incorporate the exchange rate movement in your investment decision at the onset and forget about it (at least until a major change of course happens in the country in view).

c) However, if you are still worried, exchange rate risk may be hedged by:

§ Selling futures currency contracts.

Many brokers, even discount brokers, offer combined accounts from which you can trade all sorts of financial products, including futures.

The idea of futures is very simple. In our case, when making the investment in Germany, our US investor would enter a contract to deliver the Euro he will receive from liquidating his German investment at a fixed future date, at an exchange rate determined at the time of buying the German shares and entering the futures contract.

Futures are standardized, exchange-traded products. The Chicago Mercantile Exchange (CME) is the largest futures exchange in the world. For the retail investor, it offers the E-micro forex futures whose size is 1/10 that of the normal futures contract.

The contract size varies by currency pair but you can say that one E-micro has an underlying value of $10,000-20,000 or the respective currency equivalent. Take for example the E-micro EUR/USD, ticker M6E, with a size of €12,500. Our US investor can choose to sell one such contract when he opens his position in Germany and becomes exposed to the Euro. Thus, he locks in the then current exchange rate and eliminates exchange rate risk. By selling one E-micro EUR/USD he is agreeing to deliver €12,500 at a future date (the expiration date of the contract) at the EUR/USD rate of 1.20. Hence, no matter what happens to the exchange rate in the meantime, our investor will be able to sell his Euro at $1.20/€.

Currency risk is completely eliminated if the size of the futures contract(s) matches the amount of Euro to be delivered. However, that will rarely happen because the investor wouldn’t know how much his investment will appreciate or depreciate in the time between entering the futures contract and executing it. Still, hedging the principal can be a good starting point in limiting currency risk.

Unfortunately, E-micros are available only in a bunch of major currency pairs. Check whether the currency you are considered is covered before making any plans for hedging with futures.

The more serious problem with futures is their limited life. These contracts expire quarterly and are not much spread out in the future. The fact that the most active trading in the futures market is in the nearest expiration contract means that a futures position must be rolled over periodically to maintain appropriate market exposure, running up costs.

§ Selling currency ETFs or ETNs.

ETFs and ETNs trade on the stock exchange as normal shares. The difference between them is that the former are usually a basket of assets while the latter are a debt obligation (of a major bank, normally).

Their lack of an expiration date has made currency ETFs and ETNs the instruments of choice for indefinite-term portfolio hedging. They track different exchange rates. Our US investor may prefer to short the iPath EUR/USD Exchange Rate ETN, ticker ERO, to hedge his Euro exposure.

The principle is the same as holding long and short positions is stocks, just in this case we are talking about a long (your German, Euro-denominated investment) and a short (the ETF/ETN) position in a currency (the Euro). The idea is that the two positions will cancel out and the investor will be left only with the return on his investment, not affected by exchange rate movements.

§ Buying put currency options

Similar to the currency futures, currency options are traded on the CME and constitute standardized contracts which give you the right but not the obligation to buy or sell a currency at a future date, at a predetermined price.

Again, the investor needs to check the currency pairs on which options are available, the size of the underlying contracts (no options on E-micros), and the expirations.

Buying puts on the EUR/USD gives the investor the right to put his Euro at a future date, at a fixed exchange rate. Again, rolling contracts over will be the major concern for the long-term investor.

§ Borrowing in foreign currency to finance the investment

Instead of converting dollars to Euro, the investor can borrow Euro from his broker (depending on the broker). By involving the broker currency risk is removed from the principal of the investment. However, if the investment goes against the investor’s expectations, he will be left with debt of greater value than the cost of the loan. Hence, this is more of a modification of the risk than its full elimination.

In our example the investor borrows €100 at $1.20/€ to purchase his German stock. From his US dollar deposit with the broker $120 will be used as collateral on the loan. The broker will charge interest on the loan and (in some cases) will pay interest on the deposited cash collateral.

At the time when our investor decides to close the position, he has to repay the €100 loan to the broker first and is left with the remainder.

This is how the transaction looks if the investment appreciates and depreciates by 20%.

Exchange rate Gain in Euro Gain in dollars Relative to currency trade
$1.00/€ €20 $20 +$20
$1.20/€ €20 $24 $0
$1.50/€ €20 $30 -$30


Exchange rate Loss in Euro Loss in dollars Relative to currency trade
$1.00/€ (€20) ($20) +$20
$1.20/€ (€20) ($24) $0
$1.50/€ (€20) ($30) -$30


This is how the transaction looks if the investor instead converted dollars to Euro.

Exchange rate MV in Euro MV in dollars Cost in dollars Gain in dollars
$1.00/€ €120 $120 $120 $0
$1.20/€ €120 $144 $120 $24
$1.50/€ €120 $180 $120 $60


Exchange rate MV in Euro MV in dollars Cost in dollars Loss in dollars
$1.00/€ €80 $80 $120 ($40)
$1.20/€ €80 $96 $120 ($24)
$1.50/€ €80 $120 $120 $0


As you can see, by taking a loan the investor is removing the currency exposure of the principal amount. This way he improves his result relative to the currency conversion scenario in cases when the Euro weakens against the dollar (because he has less exposure to the Euro when it depreciates). But the result is worse when the Euro strengthens (because he has less exposure to the Euro when it appreciates).

Remember the formula for calculating currency-adjusted returns from the beginning of the article:

r$ = r + s + rs

If instead of taking the currency conversion the investor goes for the loan approach, the formula changes to:

r$ = r + rs

Basically, the percentage change in the exchange rate in this equation affects only the capital gain and not the principal amount.

I hope to have shed some light on the currency risk investors face when investing abroad — how to think about it and how to limit it so it is not an impediment to taking advantage of market opportunities around the world anymore.

About the author:

dgenchev
Dimitar Genchev is a student of value.

Visit dgenchev's Website


Rating: 2.6/5 (8 votes)

Comments

batbeer2
Batbeer2 premium member - 3 years ago
Michelin

McDonalds

Canon

Nestle

Question:

1) Supposing I wanted to buy any of these, what currency should I use in order to minimize currency risk ?

2) Say I'm long Canon. I bought shares on the Tokio exchange. Am I safer shorting the Yen ?
dgenchev
Dgenchev - 3 years ago
Hi Batbeer2,

I see what you are driving at.

Obviously, I was talking about hedging the risk of the currency in which the shares are denominated, i.e., your portfolio's direct exposure to currency risk, not the company's exposure to international markets. The multinational concerns that you are pointing out certainly have exposures to many different currencies, but they are the concern of the CFO.

The investor could hedge or not hedge, depending on his exchange rate views or lack thereof, his exposure to the EUR (Michelin), CHF (Nestle), USD (McDonald's), JPY (Canon) respective to his domestic currency.

I should have mentioned that US investors using ADRs are also exposed to the currency fluctuations of the share price in its local market, even though ADRs are priced in USD, because ADRs are basically the shares of a foreign company held by a US custodian.

As to your second question, do you have views on the future of the yen? What are they? Where are you based? If I were a long-term US investor and based my views about the yen on PPP, I'd hedge my Canon position because I expect the yen to depreciate by over 1/3 against the dollar in the long run.

Also, this is not necessarily for you Batbeer2, I consider it common decency for the people not satisfied with an article and ranking it low to share their criticism for everyone's benefit.
batbeer2
Batbeer2 premium member - 3 years ago
Hi dgenchev.

>> Also, this is not necessarily for you Batbeer2, I consider it common decency for the people not satisfied with an article and ranking it low to share their criticism for everyone's benefit.

So do I. I found your article worth reading, thanks.

>> As to your second question, do you have views on the future of the yen? What are they? Where are you based? If I were a long-term US investor and based my views about the yen on PPP, I'd hedge my Canon position because I expect the yen to depreciate by over 1/3 against the dollar in the long run.

I don't have a clue. IMO it's irrelevant what currency you use to pay for a given stock. I think of it like eBay. If I bid for say.... a lathe, I don't care whether the seller is in india or Canada. Once I own the machine, it no longer matters. What matters is whether it's cheap and fit for use. If so, I can recoup my investment quickly.

The question was a feeble attempt to point out that Canon shares don't know their owner. If they don't, they can't become riskier because their owner lives outside Japan.

I'm Dutch. Am I better off shorting the dollar if I'm long Lexmark ? I don't think so.

In short, buying stocks is a solution not a cause of currency risk.

dgenchev
Dgenchev - 3 years ago
Let's take a pure example, not a gray area case. Forget about the multinationals and focus on local businesses.

Buying a foreign currency denominated asset, the investor exposes himself to currency risk. If we could buy two similar assets with the same earning power, they should be worth the same no matter where they are located.

However, it does matter where they are located because different countries have different interest rates and inflation rates which are reflected in the exchange rate of their currencies. They also are reflected in the price of the asset because they spell different economic climate for the respective assets. It is a matter of economic dispute whether the exchange rate and the investment return move in the same or opposite direction.

The consensus is that in developed countries they move in opposite directions. If poor economic conditions bring about a depreciating currency, this is good for business (especially export oriented business) and drives up its competitiveness and hence, value.

This aside, the same two assets earning, say, 10% annually will leave the investor with a completely different currency-adjusted return if in one case, the investor earns another 10% because the foreign currency appreciated, while in the other case, he loses 10% because of the currency movement.

Of course, this is only realized once the investor sells the position and converts the money back to his base currency. In the meantime, he may not bother about it, because the asset is earning the 10% he is aiming for. But in the end, he will need to convert back to his base currency. Does he want to let exchange rate fluctuations take care of themselves or does he prefer to lock in a certain rate?

I think you tried to make the following point. If we consider Nestle, which is listed in Switzerland, but, for simplicity's sake let's assume, generates 99% of its revenue in the EU. Is the US investor exposed to the Swiss Frank or to the Euro? The assets will probably be in the EU. Sales and earnings will depend on the EU consumers. Capital expenditures and (partly) raw materials will be in Euro.

In this case the stock price will be much more sensitive to movements in the Euro than in the Frank. So, it won't make sense to hedge the Frank.

In the case of multinationals, you have exposures to a bunch of currencies because of the many markets the company operates in, the different suppliers and asset bases. But these exposures are for the CFO to ponder. For the investor it would be too much work and too much uncertainty to try and estimate these exposures, adjust for the hedges already in place and, based on this, decide whether he should hedge his position or not. However, it is easy to see that he has some exposure to the foreign currency in which the stock is denominated and hedge that part of his exposure.

If you think Canon's exposure to the Yen is negligible, then don't bother hedging. If you think it has some exposure but the Yen will appreciate against the Euro, let it work for you. If you think the company will generate good returns, but they might be hampered by unfavourable exchange rate movements, lock in your rate and get the pure return.

There are many ways to skin that proverbial cat :o)

P.S. Cheers to the Netherlands. I did my Bachelor's in Groningen.
batbeer2
Batbeer2 premium member - 3 years ago
Hi dgenchev,

Monday, european leaders will announce they have solved the problem.

Everyone gets EUR 100 000. The Swiss decide to join the monetary union.

Merkel announces there's also a new and improved currency the "new euro". Old euros will be exchanged for new ones at a rate of 1:10.

Nestle issues a press release: "No news, we are open for business"

US investors, who were long Nestle and short the euro are glad.

So are US investors who were simply long nestle.
dgenchev
Dgenchev - 3 years ago
Are they?

The initial investment of EUR 100 is now EUR 1,000 because of the devaluation.

1 Euro buys $0.15, not $1.5.

The unhedged American sells his position of EUR 1,000 and gets $150, which is exactly what he invested, for a return of 0%.

The hedged American sells the EUR 1,000 at the locked-in rate of 1.50 for a 900% profit.
batbeer2
Batbeer2 premium member - 3 years ago
>> The hedged American sells the EUR 1,000 at the locked-in rate of 1.50 for a 900% profit.

I don't think so. His broker tells him he can close his short position in "new euros" 10x the amount.

Practical example: If you were short LVLT earlier this year @ 2.00, you are NOT in trouble today.

dgenchev
Dgenchev - 3 years ago
Sure.

But splits are not nearly as common for currencies as they are for stocks. Instead of having a one-off 10 for 1 split, chances are the currency will gradually depreciate and there will be no grounds for the broker not to honor the agreed upon rate.
batbeer2
Batbeer2 premium member - 3 years ago
Yes

Maybe I should just short some currency and wait.

Come to think of it, I already am. I have a mortgage.
dgenchev
Dgenchev - 3 years ago
There you go!

Done and done.

That mortgage will be gone in no time :o)

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