Currency Hedging for International Holdings
Currency Hedging for International Holdings
International investments carry currency risk—the value of foreign assets fluctuates with exchange rates even if local prices remain stable. Currency hedging uses forwards, futures, options, and swaps to manage FX exposure, allowing investors to isolate asset returns from currency movements.
Definition and Key Concepts
Currency Exposure Types
| Exposure Type | Description | Example |
|---|---|---|
| Translation | Converting foreign assets to home currency | US investor owns European stocks |
| Transaction | Future foreign currency payment/receipt | Importing goods from Japan |
| Economic | Competitive impact of FX on business | US exporter hurt by strong dollar |
Hedging Instruments
| Instrument | Characteristics | Typical Use |
|---|---|---|
| Forward contract | Custom terms, no upfront cost | Most common hedge |
| Currency futures | Standardized, exchange-traded | Liquid, margin required |
| Currency options | Protection with retained upside | Asymmetric hedging |
| Cross-currency swap | Exchange principal and interest | Long-term exposure |
Hedge Ratio Determination
Full hedge: 100% of foreign currency exposure hedged Partial hedge: Less than 100% (e.g., 50%, 75%) Dynamic hedge: Ratio adjusted based on market conditions
Optimal hedge ratio: h* = ρ × (σP / σFX) × (Exposure / Hedge Notional)
For most equity portfolios, h* ≈ 0.7 to 1.0.
How It Works in Practice
Forward Hedge Mechanics
Situation: US investor owns €10 million in European equities Current EUR/USD: 1.10 (€10M = $11M)
Forward hedge: Sell €10 million forward at 1.1050 (3-month forward rate)
Outcome scenarios (in 3 months):
| EUR/USD Spot | Portfolio Value (€) | USD at Spot | Forward Proceeds | Total USD |
|---|---|---|---|---|
| 1.00 | €10M | $10.0M | +$1.05M* | $11.05M |
| 1.10 | €10M | $11.0M | +$0.05M | $11.05M |
| 1.20 | €10M | $12.0M | -$0.95M | $11.05M |
*Forward gain/loss = (Forward rate - Spot rate) × Notional
The hedge locks in approximately $11.05 million regardless of FX moves.
Rolling Forward Hedges
For ongoing exposure, hedges must be rolled:
| Period | Action |
|---|---|
| Month 0 | Sell €10M 3-month forward at 1.1050 |
| Month 3 | Close forward at spot; sell new 3-month forward |
| Month 6 | Roll again |
| Ongoing | Repeat quarterly |
Roll cost/gain: Depends on interest rate differential between currencies.
Option-Based Hedging
Structure: Buy EUR put/USD call options
Example:
- Buy €10M put, strike 1.08
- Premium: 1.5% ($165,000)
Outcomes:
| EUR/USD Spot | Put Payoff | Net USD Value |
|---|---|---|
| 1.00 | +$800,000 | $10.8M - $165K = $10.64M |
| 1.08 | $0 | $10.8M - $165K = $10.64M |
| 1.20 | $0 (not exercised) | $12.0M - $165K = $11.84M |
Options provide downside protection while retaining upside (minus premium).
Worked Example
Portfolio:
- US pension fund
- International equity allocation: $50 million
- Currency breakdown:
- EUR: $20 million (€18.18M at 1.10)
- GBP: $15 million (£11.54M at 1.30)
- JPY: $15 million (¥2.25B at 150)
Hedge decision:
- EUR: 100% hedged (high volatility concern)
- GBP: 50% hedged (some currency view)
- JPY: 0% hedged (expect yen appreciation)
Forward execution:
| Currency | Exposure | Hedge % | Hedge Amount | Forward Rate |
|---|---|---|---|---|
| EUR | €18.18M | 100% | Sell €18.18M | 1.1025 |
| GBP | £11.54M | 50% | Sell £5.77M | 1.3050 |
| JPY | ¥2.25B | 0% | None | — |
P/L Attribution (6 months later)
Market changes:
- EUR/USD: 1.10 → 1.05 (EUR weakened 4.5%)
- GBP/USD: 1.30 → 1.35 (GBP strengthened 3.8%)
- USD/JPY: 150 → 140 (JPY strengthened 6.7%)
Currency P/L (unhedged):
| Currency | Local Return | FX Change | USD Return |
|---|---|---|---|
| EUR assets | +5% | -4.5% | +0.3% |
| GBP assets | +3% | +3.8% | +6.9% |
| JPY assets | +2% | +6.7% | +8.8% |
Hedge P/L:
| Currency | Hedge Notional | FX Move | Hedge P/L |
|---|---|---|---|
| EUR | €18.18M | -4.5% | +$900,000 |
| GBP | £5.77M | +3.8% | -$285,000 |
| JPY | None | — | $0 |
Net impact:
- EUR hedge added $900K (protected against EUR weakness)
- GBP hedge cost $285K (gave up some GBP strength)
- JPY unhedged gained $1M additional from yen strength
VaR Comparison
Unhedged FX VaR (95%, 1-year): = $50M × 10% weighted FX volatility × 1.65 = $8.25M
Hedged FX VaR:
- EUR: $0 (fully hedged)
- GBP: $7.5M × 8% × 1.65 = $990K (50% unhedged)
- JPY: $15M × 12% × 1.65 = $2.97M (fully unhedged)
- Total: ~$4M
VaR reduction: 52%
Risks, Limitations, and Tradeoffs
Hedge Costs
Forward points: Cost depends on interest rate differential.
| Currency Pair | Rate Differential | Annualized Cost |
|---|---|---|
| EUR/USD (2024) | -1.5% (US > EUR) | -1.5% carry cost |
| GBP/USD | -0.5% (US > GBP) | -0.5% carry cost |
| USD/JPY | +4.0% (US > JPY) | +4.0% carry gain |
Hedging high-yield currencies into USD is costly.
Basis Risk
Sources:
- Hedge tenor differs from investment horizon
- Asset value changes between rebalancing
- Currency of underlying assets not perfectly matched
Opportunity Cost
Full hedge eliminates:
- Positive currency moves
- Diversification benefit of currencies
Research suggests: Currencies add volatility but may have positive expected return in long term.
Common Pitfalls
| Pitfall | Description | Prevention |
|---|---|---|
| Over-hedging | Hedging more than exposure | Track asset values |
| Roll timing | Gaps between hedge rolls | Overlap rolling hedges |
| Wrong pair | Hedging USD/EUR when exposure is EUR/USD | Verify direction |
| Ignoring costs | Not budgeting for hedge expense | Calculate annual cost |
Strategic Considerations
To Hedge or Not
| Factor | Suggests Hedging | Suggests Unhedged |
|---|---|---|
| Volatility tolerance | Low | High |
| Investment horizon | Short | Long |
| Currency view | Negative on foreign | Neutral/positive |
| Correlation | Low with equities | High with equities |
| Cost | Low | High |
Partial Hedging Strategies
| Approach | Description |
|---|---|
| Fixed ratio | Always hedge 50% |
| Valuation-based | Hedge more when currency expensive |
| Momentum-based | Hedge more in downtrends |
| Regime-based | Hedge more in volatile periods |
Checklist and Next Steps
Pre-hedge checklist:
- Identify foreign currency exposures by currency
- Calculate exposure amounts
- Determine hedge ratios by currency
- Evaluate hedge costs (forward points)
- Select instruments (forwards, options, swaps)
- Establish rebalancing frequency
Execution checklist:
- Obtain forward/option quotes
- Verify counterparty documentation
- Execute hedge trades
- Confirm trade details
- Document hedge rationale
Ongoing management:
- Track hedge effectiveness
- Monitor asset value changes
- Plan roll schedule
- Attribute returns to currency vs. local
- Review hedge policy quarterly
Related articles:
- For interest rate swaps, see Interest Rate Risk Hedging with Swaps
- For tail risk protection, see Tail-Risk Hedging Strategies