Currency hedging

Currency hedging, also known as foreign exchange hedging, refers to the practice of removing the effects of currency fluctuations from the returns obtained by a holding that is valued in a different currency.Roberts et al., Vanguard Research, The portfolio currency-hedging decision, by objective and block by block, August 2018, viewed December 14, 2019.Dan Bortolotti, Can currency-hedged ETFs protect you?, MoneySense, July 31st, 2017, viewed February 25, 2018. 
Foreign equities (US equities, international equities, emerging markets), expose the Canadian investor to currency fluctuations, which may reduce, or add to, yearly returns. This is also true if buying foreign bonds. 
In the case of foreign equities held over several decades, the dominant opinion on the Financial Wisdom Forum is not to hedge the currency exposure because:
*over several decades, the currency fluctuations should even out;R. Balakrishnan, Currency Fluctuations and Stock Market Returns, Canadian Capitalist, May 2010, viewed January 5, 2015 
*hedging adds to costs and is not precise; and 
*for Canadians, hedging may add to the volatility of portfolios.Dan Bortolotti, Why Currency Hedging Doesn’t Work in Canada, March 2014, viewed December 30, 2014
In contrast, foreign bonds should always be hedged, as unhedged global bonds have 2.5 times the volatility of hedged global bonds.Going global with bonds: Considerations for Canadian investors, Vanguard Research (January 2014), viewed April 24, 2024.
==Currency hedging for foreign stocks==
===An example===
For example, if a Canadian investor purchased a US-based exchange-traded fund (ETF) tracking the S&P500 (and thus valued in US dollars) and the index went up 10% but the Canadian dollar also went up 10% versus the US dollar, the currency change would cancel out the valuation change. A currency-hedged fund would, if the hedging was performed perfectly and at zero cost, cancel out the rise in the Canadian dollar, in this case enhancing the observed return. However, if the Canadian dollar were to fall, a currency-hedged fund would return less money.
===Costs for mutual funds and ETFs===
Although it is possible for investors to purchase currency-hedged versions of some mutual funds and ETFs, the costs of currency hedging are a matter of some dispute. They have been estimated by portfolio manager Dan Hallett, who recommends currency hedging for those investors who wish to have the currency protection, as 0.4 to 0.5%Rob Carrick, The pluses - and minuses - of currency hedging, Globe and Mail, June 6, 2009. Viewed August 15, 2009. A tracking error comparison between the iShares S&P 500 Index Fund (CAD-Hedged) ETF XSP and the S&P500 is shown below. BlackRock Asset Management Canada Limited, Tracking Error Charting Tool, XSP, viewed January 16, 2012. This tracking error, which includes the total of the 0.24% MER, currency hedging costs, and any portfolio mismatching amounts to about 1% per year according to the BlackRocks's data:
:Note that prior to November 15, 2005, the investment objective of XSP was to replicate, to the extent possible, the performance of the S&P 500 Index. After November 15, 2005, the investment objective of XSP is to provide long-term capital growth by replicating, to the extent possible, the performance of the S&P 500 Hedged to Canadian Dollars.XSP - iShares S&P 500 Index Fund (CAD-Hedged) Annual MRFP, viewed January 16, 2012
Image:XSP_Tracking_Error_to_31-Dec-2011.PNG‎
Another tracking error chart can be obtained from BigCharts,BigCharts, plot of CA:XSP versus S&P500, viewed January 17, 2012, and is shown below. This chart suggests an error of about 2% per year:
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An up-to-date version of the BigCharts graph can be obtained in
this link. Although the two graphs disagree significantly in the size of the total tracking error, it is nevertheless clear that currency hedging will add significant costs above the 0.24% MER.
===Other arguments against hedging===
====Increased volatility?====
A classic argument in favour or currency hedging it that it lowers volatility, but this is apparently not true for Canadians purchasing foreign stocks. It appears that the reverse is true: hedging increases volatility:
:Why isn’t hedging effective in Canada? The Pyramis researchers explain that the US dollar, euro and Swiss franc tend to have negative correlation with the global equity markets. (Recall that when all risky assets plummeted in 2008, the US dollar soared.) Negative correlation is what diversification is all about: any part of your portfolio that goes up when equities go down is a welcome addition, so exposure to these currencies is a benefit, and hedging wipes it out. As the J.P. Morgan authors write: “The hedge will tend to produce profits at the same time that equity markets are advancing, and produce losses when equities are falling.” In other words, it magnifies volatility rather than reducing it.
====Currency fluctuations even out over several decades====
The following table shows the volatility of the US dollar against the Canadian dollar over periods of one year to 20 years (between 1960 and 2012): G.G. Dallal, Long-Term Strategic Asset Allocation, CIBC Asset Management, 2013, viewed January 30, 2015
:
 	Annualizedstandarddeviation (%)	Maximumannualizedreturn (%)	Minimumannualizedreturn (%)
One year rolling	5.8 	29.0 	-19.1
5 years rolling 	2.9 	4.8 	-9.5
10 years rolling	2.0 	3.7 	-4.8
20 years rolling	0.9 	1.8 	-1.6
Over 20 year periods, currency fluctuations even out, so hedging is not needed for foreign stocks.
====Matching non-Canadian dollar expenses====
Investors who face significant US-dollar expenses - say, for "snowbirding" in the US - may not wish to hedge so that the currencies of their investments better match the currencies of their expenses.
====Behavioral issues====
In registered accounts, it is very easy to switch back and forward between unhedged and hedged foreign stocks, for example using mutual funds or ETFs, since there is no tax consequence of switching. Thus there may be a temptation to try predicting currency movements, and position the portfolio accordingly. Of course, if the prediction is correct, returns will be enhanced, but currency variations are difficult to predict, and a policy of varying hedging may instead hurt returns:Fisher KL, Statman M (2003) Hedging currencies with hindsight and regret. Viewed December 15, 2019.
:Behavioral investors follow a cycle of hindsight and regret where they conclude, with hindsight, that they could have seen with foresight the securities that would make them rich, and suffer the pain of regret because they did not. (...) Currencies present special temptations since, as Solnik (1998) wrote, "Everyone, even a simple tourist, has an opinion on currencies" and many are happy to magnify these temptations. (...) We do predict that most investors, driven by hindsight and regret, will continue to jump from bets on hedged portfolios to bets on unhedged ones, forever searching for sure winners.
A safer approach, to avoid mistakes, is to decide for or against hedging of foreign stocks, write it down in one's investment policy statement, and stick to that.
==Currency hedging for foreign bonds==
Foreign bonds should always be hedged, unless one wishes to speculate on currency movements. For long-term investors, bonds are supposed to provide stable, low-risk investments, but unhedged global bonds are quite volatile:
:On average, currency has made unhedged (global) bonds over 1.5 times as volatile as an investment in Canadian bonds and 2.5 times as volatile as the underlying global bonds with currency exposure hedged away.
Furthermore, hedged foreign bonds are better portfolio diversifiers than their unhedged equivalents: 
:We can conclude that hedging away the movement of the Canadian dollar allows the properties of the underlying (global) bonds to play the traditional fixed income role of risk reduction. The imperfect correlation of foreign currency with the other stock and bond assets is not enough to mitigate the effects of its higher volatility. In addition, many investors may already have currency exposure in their global equity allocation, meaning that the currency exposure of unhedged bonds isn’t adding anything that a balanced investor doesn’t already have.
==Hedging in a portfolio context==
The currency hedging decision can be taken for each asset class, but it can also be examined on a whole portfolio basis. At the portfolio level, the foreign currency exposure, and the hedging decision, depends on asset allocation and the investor's home country bias.
==See also==
*Currency conversion
*Home country bias
*Norbert's Gambit
==References==
==Further reading==
* 
* 
* 
==External links==
*Wikipedia, Foreign exchange hedge
*Raymond Kerzérho, Currency-Hedged S&P500 Funds: The Unsuspected Challenges, PWL Capital Inc. September 2010 paper
*Pros and cons of currency hedging | Advisor.ca
* Canadian Portfolio Manager Podcast, episode 9, Hedging your bets, with currency-hedged ETFs
Category:Foreign exchange
Category:Mutual funds and ETFs
Category:Investment management