The introduction of the euro has rekindled the discussion about the merits of international diversification, in which the question of currency risks plays a central role. Does it in principle make sense to enter into a currency risk, and will this risk be rewarded with higher returns? There are two schools of thought. Some emphasise the benefits of diversifying into foreign investments while others claim compensation for assuming a currency risk is not worth the exposure. As it happens, currency hedging is definitely worth considering when investing in bonds, but is often not justified in the case of equities.
Currency risk can have a substantial impact on the portfolio’s total risk exposure. For example, an investment in bonds denominated in Swiss francs presents a risk of 3.3%, while one in foreign bonds carries considerably more. Since January 1985, foreign currency investments have carried a risk ranging from 5.6 (Germany) to 13.1 (US).
It’s not surprising that between 60% (Germany) and 80% (US) of the risk associated with foreign-denominated investments is due to exchange rate fluctuations. This percentage is slightly lower for equities – between 10% (Germany) and 40% (US). Even so, investors have to be compensated sufficiently to accept such risks and it is precisely this aspect that is thrown into question as foreign-currency investments are a zero-sum game. If two investors from different countries invest in the other’s currency, they are exposed to similar risks. However, the returns may differ substantially – once one investor makes a currency-related gain, so the other faces a loss. As far as investors are concerned, therefore, currency fluctuations present an unsystematic risk that the market doesn’t compensate.
The logical conclusion is initially simple and clear-cut: where foreign investments are concerned, every currency risk must be eliminated by hedging. But it’s not quite so simple as the situation is different for equities and bonds. A share amounts to a participation in the assets of a business. A company is exposed to currency risk (among other risks).
Results of the empirical analysis
1. In international equity investments, the diversification effect dominates the currency risk.
2. In the case of equity investments, currency hedging only slightly reduces the portfolio risk and is therefore not recommended.
3. With bonds denominated in foreign currencies, the diversification effect may not be enough to compensate for the dominant effect of foreign currency fluctuations.
The foreign currency risk associated with equities therefore depends neither on the local currency of the stock market where the shares are traded, nor on the currency of the country where the company is domiciled. The economic characteristics of the company are far more important. This makes currency hedging for equities an extremely difficult undertaking, since the purchase of a US stock not only requires hedging in US dollars but in a number of different currencies, depending on the company’s activities.
In fact, the currency risk only represents a small proportion of the overall risk associated with equities and can be compensated for with effective diversification. Investing outside national borders has two conflicting consequences for dividend-bearing securities: it increases currency risks while potentially reducing overall risk. This is confirmed in the findings of the graph. An internationally diversified portfolio (Global) presents, from a Swiss franc perspective, a lower risk than investments in the home market. A portfolio with currency hedging (Global Hedge) reduces overall risk marginally. This simple illustration shows diversification and not currency hedging is the most important factor for investing in international equities.
The characteristics of face-value investments are that future receivables are fixed in the form of a nominal amount. This means future payments depend on interest rate movements. Bonds denominated in foreign currencies therefore have a currency exposure equivalent to the investment volume in the local currency. In other words, the value of the bonds depends on currency movements.
Compared with equities, foreign currency bonds expose the portfolio to higher risks. Nevertheless, the effect of diversifying has to be considered here as well. Because of the different interest rate trends, diversification in bond markets helps reduce portfolio risk, though not enough to compensate for the additional currency risks.
Compared with individual bond markets, a broadly diversified portfolio (Global) has more attractive risk properties. The risk reduction is too small, however, to offer an acceptable alternative to investments in the home market. For the portfolio with currency hedging (Global Hedge) the situation is different and the risks are barely more than those for Swiss franc bonds. The obvious conclusion is that currency hedging is most important for fixed-income securities.
One of the aims of a single currency was to eliminate exchange rate fluctuations within the Euro-zone. In addition, bond investors are able to benefit from an enormous market, high liquidity and more credit ratings. On the other hand, this means the credit risk and its control will assume more importance in future. The effects are less obvious for equities, as the currency risk impacts primarily on a company’s profits. Even so, the overall trend is towards a benign effect here as well, since most of the production and sales are conducted within the eurozone.
Thomas Häfliger, Daniel Hannemann and Daniel Wydler are at Pictet Asset Management in Geneva