As currencies around the globe continue to fluctuate, investors have grown increasingly aware of the impact of currency movements on international investments. Currency risk concerns are justifiably widespread – investors benchmarking to the most widely used international indices can own securities denominated in numerous currencies, thereby exposing them to currency risk.
Currency hedging can be an effective approach to mitigating currency risk, such that an investor holding foreign securities can be protected from exchange rate changes. One of the more common currency hedging strategies is purchasing forward contracts, which is an agreement to buy or sell a currency at a fixed price on a later date. This enables investors to lock in an exchange rate, thereby insulating them from rate fluctuations.
Pursuant to this currency hedging strategy, FTSE uses spot and forward contract rates to calculate currency hedged indexes. This methodology allows exposure to the returns of the foreign assets in the index without exposing the index to the volatility of exchange rates.
Whether a US investor would benefit from currency hedging is dependent on how the US dollar moves relative to the currency in which the foreign investment is denominated. If the US dollar is appreciating, the investor would be holding assets in a depreciating foreign currency and therefore a US dollar hedged strategy would be advantageous. Conversely, if the US dollar is depreciating relative to the foreign currency, the investor would benefit from holding securities in a strengthening foreign currency. In this case, a US dollar hedged strategy would underperform an unhedged strategy.
This dynamic is evident when examining the FTSE Developed Europe ex UK Index relative to the FTSE Developed Europe Ex UK Hedged USD Index in different currency environments. As the index is comprised of over two-thirds euro-denominated securities, the performance of the US dollar relative to the euro significantly impacted index returns. As demonstrated below, the US dollar depreciated relative to the euro in 2013, and as a result the unhedged index delivered stronger performance. The opposite is true for 2014, when an appreciating dollar versus euro led to higher returns for the hedged index.
Source: FTSE as of December 31, 2014. The “Hedged Index” refers to the FTSE Developed Europe Ex UK Hedged USD Index. The “Unhedged Index” refers to the FTSE Developed Europe ex UK Index. Past performance is no guarantee of future results.
The above data demonstrates that it is important for investors to recognize there are two considerations when determining whether a currency hedging strategy could be advantageous. It is imperative to evaluate both the currency exposure of their investments and the broader currency environment.
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