Explore how currency hedging solutions can help manage risk
As portfolios have diversified internationally, it has become increasingly important for institutional investors to manage currency risk. While geographical diversification is a key tool in spreading investment risk, investors are presented with another, unintended risk, that of international currency exposure.
In the short term, currency volatility can be beneficial or detrimental. However, it is generally agreed that over the long-term investors should not expect to gain from a passive exposure to developed market currency exposures.
We explore how currency hedging solutions can help investors manage these risks and also provide a potential source of return which is uncorrelated to their other investments. In particular, we look at some of the practical aspects of managing currency risk:
- The starting point: setting up a strategic currency hedge ratio
- Passive currency overlays: how to implement the strategic hedge ratio as efficiently as possible and avoid the pitfalls
- Dynamic currency overlays: how to deviate from the strategic hedge ratio to generate reliable and repeating returns
- Emerging market currency overlays: overcoming the additional barriers when investing in developing markets
- Customisation: Three ways to increase the customisation of a currency solution
- Implementation considerations: structure, liquidity and specialism
Currency: A major source of risk and uncorrelated return opportunity (returns versus the US dollar 1990 to 2019)
Source: Bloomberg, Insight Investment, as at March 2020.
Past performance is not indicative of future results. Investment in any strategy involves a risk of loss which may partly be due to exchange rate fluctuations.
The performance results shown, whether net or gross of investment management fees, reflect the reinvestment of dividends and/or income and other earnings. Any gross of fees performance does not include fees and charges and these can have a material detrimental effect on the performance of an investment.
Any target performance aims are not a guarantee, may not be achieved and a capital loss may occur. Strategies which have a higher performance aim generally take more risk to achieve this and so have a greater potential for the returns to be significantly different than expected.
Portfolio holdings are subject to change, for information only and are not investment recommendations.
Associated investment risks
Currency risk management
Currency hedging techniques aim to eliminate the effects of changes in the exchange rate between the currency of the underlying investments and the base currency (i.e. the reporting currency) of the portfolio. These techniques may not eliminate all the currency risk.
Derivatives may be used to generate returns as well as to reduce costs and/or the overall risk of the portfolio. Using derivatives can involve a higher level of risk. A small movement in the price of an underlying investment may result in a disproportionately large movement in the price of the derivative investment.
Investments in emerging markets can be less liquid and riskier than more developed markets and difficulties in accounting, dealing, settlement and custody may arise.
Where leverage is used through the use of swaps and other derivative instruments, this can increase the overall volatility. Any event that adversely affects the value of an investment would be magnified if leverage is employed by the portfolio and losses would be greater than if leverage were not employed.