Currency Risk

In general, a currency futures contract locks in the exchange rate between two currencies. A company in one country selling products in another country can eliminate currency risk by purchasing a sufficient number of such futures contracts. Currency gains and losses represent a “difference in exchange value of the foreign currency and the domestic currency between the time the investment was bought and time it was sold” (Barron’s, 2014). Hedging can offset different types of investment risk, depending on what is being hedged (i.e., currencies, interest rates, cost of raw materials using for production, jet fuel for airlines, etc.).

 

Findings from a study by Arnott (1996) showed currency hedging among global and foreign mutual funds was less than expected; ~ 1/3 of foreign stock funds hedge on a regular basis while 2/3 either hedge infrequently or never. A different study by Penn (1994) noted currency risk is likely to be more of a concern for foreign and global bond portfolios than their stock counterparts. For example, if interest rates in a foreign country fall, stock prices may go up; such gains could easily surpass any currency loss to a U.S. investor owning stocks from the country. In the case of bonds, gains due to a slight rate decrease may not offset currency loss to the same U.S. investor.

 

Since the great majority of foreign and global funds do little, if any, currency hedging, it is fair to conclude such a strategy is not worthwhile, particularly for medium- and long-term investors. However, there have been times when currency hedging has benefited U.S. investors owning foreign securities. A paper by Rothschild (1998) shows 23% of 1996 foreign fund returns were due to hedging, but only 13% of returns were due to hedging in 1997. Bernstein (1999) concluded the best strategy for moderate and high risk portfolios was to avoid funds using any kind of currency hedging.