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Stating the strong case for hedging

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Does currency hedging affect re-turns and does it reduce risk or not? I believe we can arrive at definitive answers to this question.

Generally the change in value for international investors caused by currency movements is an unwanted additional risk.

If this additional risk provides no increase in expected return, it is detrimental to the portfolio, and the ans-wer to our question seems straightforward - hedge it out. However, this simple (and in my view correct) ans-wer unfortunately tends to get de-flected by a number of misleading as-sertions:

(i) Currency risk washes out in the long term - it is a zero sum game."

(ii) "My domestic currency tends to be weak and so hedging will damage my overall return."

(iii) "Foreign equities show lower correlation with domestic equities if they are left unhedged, therefore hedging reduces the diversification benefit of investing abroad."

I would agree with the first statement, provided the investor has a genuinely long-term time horizon. A general analysis shows that currencies provide no expected return for any investor wherever he is located, and therefore hedging also has a zero expected return. Over the very long term and across a broad spectrum of currencies, it makes no difference to return whether you hedge or not. This is therefore as much an argument for hedging as it is against it. Furthermore, I know of no investor who does not have at least a passing interest in short to medium term returns.

Considering the second statement, let's look at a traditionally "weak" currency such as sterling. Fig.1 shows that over the period 1980-1996 sterling was indeed generally weak against the deutschemark and a British invest-or investing in Germany would have enjoyed currency gains. However, had he hedged his currency exposure in the forward foreign exchange market, his gains would have increased! This is simply because German interest rates have been consistently lower than sterling interest rates which means that the investor would have been paid a premium for hedging his deutschemarks in the forward market. As it turns out, this premium would have come to more than the currency gains available in the spot market. Looked at in these terms, sterling has not been a weak currency at all, in fact it has been rather strong. When we look at other currencies, similar patterns appear, and it is not possible to assess whether or not hedging would have been worthwhile simply by looking at spot rate movements.

What about the diversification ef-fect? Certainly currency movements reduce the correlation between foreign stocks and domestic stocks, but is this necessarily a good thing? It is only useful if the volatility of the total portfolio is reduced as a result, and this is generally not the case. This is because currency returns have a multiplicative effect on foreign stocks - increasing their volatility substantially, but without increasing ex-pected return.

Taking on currency risk is not like diversifying into another market sector or asset class, because other holdings are not diluted. There is actually a gearing effect because no additional investment is required - currency risk is obtained on credit. Fig. 2 shows the S&P 500 from a German investor's point of view and clearly illustrates the reduction in volatility brought about by currency hedging. We have found that it is nearly always the case that combining hedged investments into a portfolio produces lower overall vol-atility, even though these investments may be more highly correlated than unhedged.

So what do we conclude? Hedging currency risk has no expected impact on return, yet can be expected to reduce overall volatility. This makes it a very attractive proposition indeed, and we would have to say that hedging currency risk is almost certainly worthwhile for international investors.

Are there no negatives at all? Unfortunately there are, but these are of a practical, rather than a theoretical nature. Currency markets are ex-tremely liquid and transaction costs are very low indeed, but they are not negligible, also hedging has to be im-plemented by someone and this will involve either administrative costs or management fees to an external supplier. For these reasons, in practice hedging has a small but negative im-pact on expected return. Finally the hedging activity will produce cashflows (positive and negative) which can be quite large and which need to be managed in the context of the whole portfolio.

In spite of these considerations I believe that hedging currency risk is worthwhile. Furthermore, we have only been talking about 'passive' hedging (ie a simple program of neutralising the risk with a series of rolling forward contracts). Once the principle of currency hedging has been accepted, the investor should also assess the benefits of more active programs. These may be designed to reduce risk but with the additional prospect of increasing return, and can also be useful in minimising negative cashflows.

As international investing becomes more the 'norm' for European in-vestors, so currency risk becomes an ever more important issue. Hedging this unprofitable risk has far more to gain than to lose and should certainly be considered worthwhile, whether to do so actively or passively involves rather more arguments which unfortunately I do not have the space to develop here.

Mike Shilling is a director of Record Treasury Management in Windsor."

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