What is currency hedging and why should you care? In simple terms, currency hedging is the act of protecting your investments against changes in currency exchange rates between countries. Currency hedging is used by global investors and companies that conduct business internationally, and can be viewed as an insurance policy which limits the impact of foreign exchange risk.
Let’s say, for example, you are a U.S. based investor and think the Japanese stock market is due for a strong rise. You want to get exposure to the Nikkei 225 and so you purchase $100,000 U.S. worth of a Nikkei 225 ETF such as the MAXIS Nikkei 225 Index ETF (NKY ).
Continuing with our example, a year from now the Nikkei 225 is up 20% and you sell out. Your investment account should show 120,000 USD, right?
WRONG – your account will show the 20% gain in your investment and the relative change between the U.S. dollars and the Japanese yen since the time of your purchase. If USD appreciates 20% against the yen during this period, your account will show no gain once the transaction is converted back to USD.
Why does this happen?
As a U.S. based investor you are entering the global markets with USD, and presumably you will want to withdraw USD from your investment account when you need it. However, to buy into a foreign stock market, your USD must first be converted into the native currency of the respective market.
The foreign exchange markets constantly fluctuate, and when you convert USD into another currency you are essentially taking a long position in that currency, regardless of what you purchase with it. So when you sell out of the foreign market (hopefully with some gains) and wish to move your capital back to your U.S. based investment account, you will have to convert your capital back into USD in order to complete your transaction and spend your USD.
As you can see in the example above, your conversion to and from USD can have a dramatic impact on the performance of your global investment. Great gains in foreign markets can be erased by declines in relative currency values and vice versa.
How to hedge foreign exchange risk?
- Futures contracts: a currency futures contract is a straightforward hedging tool. The contract allows the holder to buy or sell a currency at today’s price and may be settled at an agreed upon point in the future. Futures contracts are regulated and exchange traded, which reduces the counterparty risk. The price of the futures contract is calculated using the time value of money and adjusted for the interest rate differential between the two currencies. These contracts are marked-to-market daily and may be settled at anytime before expiration.
- Currency SWAPs: a currency swap involves two parties that exchange currency with one another at an agreed upon interest rate. For example, a U.S. company doing business in Japan and a Japanese company doing business in the U.S. exchange USD and Yen with one another. Large institutions and multinational companies transact swaps because swaps do not appear on balance sheets and in order to reduce the cost of borrowing. Swaps are not usually available to private investors.
- Forward contracts: much like a futures contract, a forward currency contract allows the holder to buy or sell a currency at today’s price, while delaying settlement of the contract to some agreed upon point in the future. The major difference between forwards and futures is that forward contracts are private agreements which are traded over-the-counter between two parties instead of by an exchange. In addition, the settlement of forward contracts is different than futures: forward contracts may only be settled at their agreed settlement date and are not marked-to-market daily.
K.I.S.S. - Keep It Simple, Stupid
If you want to invest directly into foreign equity markets, it is necessary to protect against foreign exchange risk, but it doesn’t have to be complicated. There are many high quality ETFs that allow investors to gain currency hedged exposure to international markets. These ETFs use currency futures to protect against foreign exchange risk while directly investing in international markets. Here are a few major currency hedged ETFs:
- WisdomTree Europe Hedged Equity (HEDJ )
- iShares Currency Hedged MSCI Japan (HEWJ )
- Deutsche X-trackers MSCI Emerging Markets Hedged Equity ETF (DBEM )
For more currency hedged ETFs, check out the Currency Hedged ETF list
The Bottom Line
Currency hedged ETFs are the easiest way for an investor to gain exposure into targeted international markets while limiting their exposure to foreign exchange risk. Entering into currency futures contracts can be daunting for inexperienced investors, and is only necessary if the foreign investment is in an exotic region not currently covered by an ETF. Otherwise, it usually makes sense for investors to use currency hedged ETFs and take advantage of the professional portfolio assistance they afford.
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