In Thinking About Your Investments we discussed framing your financial view in a way independent of a currency anchor. A currency is a security like any other, except we use it as our default unit of value. But as we discussed, this introduces distortion into our thinking because a currency is not inherently any more superior than other assets as a standard of value. Our choice may be one of habit, or even government fiat, but it’s not one forced by the laws of economics.
We also cited some ways in which our investment decisions might be improved as a result of removing these distortions. Let’s take a look at another one.
Investors are sometimes urged to hedge investments for currency risk. There are a number of investment funds on the market with such hedging built in. For example there are a number of exchange traded funds (ETFs) marketed in the US for investing in other national stock markets on a currency hedged basis. This basically means that the investor receives, after expenses, the return of that foreign market in the foreign currency, but translated into US dollars. A European stock fund might return, say, 15% in euros, and the hedging operation then translates that into a gain of 15% in dollars.
But looked at in our clearer frame of reference, we can see flaws in the line of thinking the strategy is based on. It assumes that the local currency performance of that market is the “real” performance, and that if we invest on an unhedged basis we incur an additional risk of loss due to currency translation. But this isn’t true … if we own those stocks the only investment performance we will experience is that of the stocks. If we hedge for “currency risk”, in fact we’re layering on an additional speculation on the relative performance of the currencies involved.
Why? No currency is absolute. The performance of European stocks as measured in euros is no more real than the performance of those stocks as measured in yen. In the first case, the return being measured is the ratio of return of the European stocks to that of the euro. It’s a relative return, not an absolute one. In the second case, we’re looking at the return of European stocks relative to the Japanese yen. While it may seem natural enough to use European currency to measure the return of European stocks, there’s nothing inherently different in using another choice of units … no matter what unit we select, we cannot eliminate the variation in the unit itself from the return calculation. All prices are ratios … ratios of the value of the thing being priced to the value of the currency used to price it.
The return of those European stocks is the same no matter unit what you use to measure it. If the numbers come out different measured in different currencies, it’s solely due to changes in the value of the currencies.
This doesn’t mean of course that there’s never a valid reason for currency hedging. But it does mean that it’s adding, not subtracting, a currency risk.
5 thoughts on “Currency Hedging Investments”
I’ll use a simple, hypothetical example.
1/1/2020 Buy USD 100,000 AUD USD Exchange rate = 0.65, AUD 153,846
USD 100,000 buy 1,000 shares of XYZ at USD 100 per share
1/1/2021 Sell 1,000 shares of XYZ at USD 120 per share. Return on investment in USD 20%
1/1/2021 AUD USD Exchange rate = 0.85, sell USD 120,00 buy AUD
1/1/2021 AUD 141,176 received. Return on investment in AUD -8.24%
It’s late at night here and I may have made a simple error in the above. However, if not, does not the above example prove that one MUST hedge currency risk, in order to maintain return on investment?
After further investigation from my previous contact, the best hedging strategy I believe are to use the futures market. I realise one has roll costs on a regular basis, so not a perfect hedge, but far better than no hedge at all.
Be interested to hear your thoughts. And, apologies in advance if there is an error in my example. Normally, I’d double check it but don’t have time, right now.
“If the numbers come out different measured in different currencies, it’s solely due to changes in the value of the currencies.”
Clearly, my example highlights this statement of yours, hence we are in agreement. However, my example shows that it is necessary to hedge currency risk, as there is no point in making a profit in USD but due to movement in the AUD USD exchange rate, seeing this USD profit turn into a loss in AUD.
Thanks for the comments, Peter. I sympathize with the sentiment, but must ask the following: Which was the real return?
Let’s use your figures for XYZ. Return in USD is 20%. Return in AUD is -8.24%.
All we really know is that XYZ outperformed USD by 20% and that it underperformed AUD by 8.24%. From these data we know nothing of the return of XYZ itself. To conclude that one must hedge in order to preserve the 20% return assumes that it was somehow more real than the -8.24% return to begin with.
I submit that we have no way of establishing whether XYZ even rose or fell. We would have exactly the same result if XYZ stayed constant in value and USD declined by 16.67%. Due to the loss in value of the USD, it would take 20% more to buy XYZ at the same value. A 20% higher price in USD.
Conversely, USD could have remained constant in value while XZY rose. You’d get the same result. A 20% higher price in USD.
We have no way of telling from these data which happened, or any of an infinite range of possible absolute returns. We only know the relative return.
We do know however that the return in AUD was -8.24%. But this means that the AUD must have appreciated against the USD by the combined differential (30.77%). AUD outperformed XYZ by the inverse of -8.24% (8.98%). Between the three securities, AUD performed best, followed by XYZ, with USD coming in at a distant third.
We still don’t know what the absolute performance of any of these was. We only know their relative performances.
What you’re doing by adding the currency hedge isn’t preserving some unknown absolute performance of XZY itself (we can’t even say what it is), but rather the differential between XYZ and USD, and then translating that into AUD. The only way to have pure exposure to XYZ alone is to own it unhedged.
Hedging the position is actually adding a currency speculation to your stock investment. It may or not be a profitable one. Your example highlights this … the biggest return differential had nothing to do with XYZ itself … it was the differential between AUD and USD. You would have done better to just short USD against AUD and leave XYZ out if it.
Hi Bill, Thanks for your reply and taking the time to flesh out my example and expose its short comings.
Okay, another hypothetical example.
If I did short USD with the AUD USD at 0.65 on 1/1/2020 and then on 1/1/2021 with the AUD USD at 0.85 I closed my short position, where I had shorted USD 100,000.
In AUD, this is a return of 23.53%, nominal, assuming I’ve done the numbers correctly. If I had a magic ball, or some way of accurately measuring the rate of inflation in Australia between 1/1/2020 and 1/1/2021, and it was 10%, can one then say that the real return I made on the short USD position is 13.53%?
Or, is this still flawed in some way?
P.S. Please delete duplicate post. The website displays unusual behaviour in that if one makes a post, and then attempts to clarify the post with a second post, it claims the second post is a duplicate. I wasn’t sure if the second post above would be lost or not. Then, I tried to make the second post, using a different browser, a second time. So, please go ahead and delete the duplicate post, which I’m sure you will, if you can.
That sounds about right to me, Peter. The AUD appreciated 30.77% in terms of USD. That translates into a USD loss of 23.53% in terms of AUD.
We could put a finer point on the math. If price inflation in AUD was 10%, you could interpret that to mean the AUD fell to 1/1.1 of its former value, for a loss of 9.0909%. (Percentages can be messy!)
If your trade resulted in a gain of 23.53% in AUD, based on this you could find your real return from 1.2353/1.1 = 1.123 or a 12.3% gain.
I deleted the first duplicate post on the assumption the second was an edit. As far as I know my site platform doesn’t allow guests to edit their comments, but if I can find a way to do it, I’ll add that capability. I like to edit mine at least, especially considering the number of errors I find after posting;-)