What Is Currency Hedging - Controlling the Hidden Risk in Overseas Investments

When investing in foreign assets, investors simultaneously carry two sources of return. One is the price movement of the investment itself (stock or bond returns), and the other is fluctuations in exchange rates. For example, even if a U.S. stock rises 10%, if the yen strengthens by 10% at the same time, the yen-denominated return is essentially zero. Conversely, if the yen weakens, the currency gain is added on top of the stock price increase. Currency hedging is the technique used to suppress this exchange rate fluctuation risk.

The basic mechanism of currency hedging involves using forward contracts to lock in a future exchange rate at the current point in time. Specifically, an investment trust holding foreign-currency-denominated assets enters into forward contracts for the same amount, offsetting losses from yen appreciation. However, this "insurance" comes at a cost. The hedging cost is determined by the short-term interest rate differential between the two countries, and a cost arises when Japan's interest rate is lower than the investment destination's rate. As of 2024, the short-term interest rate differential between Japan and the U.S. is approximately 4-5%, so the hedging cost for U.S. dollar-denominated assets reaches 4-5% per year.

How to Calculate Hedging Costs - The "Insurance Premium" Determined by Short-Term Rate Differentials

Currency hedging costs can be approximated by subtracting Japan's short-term interest rate from the investment destination's short-term interest rate. Precisely, it is determined by the forex swap points (the difference between forward and spot rates), but in practice this closely matches the short-term rate differential. The formula is: Hedging Cost ≈ Destination Country's Short-Term Rate − Japan's Short-Term Rate.

Let's look at specific numbers. As of the end of 2024, the U.S. federal funds rate (policy rate) is 4.25-4.50%, and Japan's uncollateralized overnight call rate is around 0.25%. Therefore, the hedging cost for U.S. dollar-denominated assets is approximately 4.0-4.25%. The eurozone policy rate is around 3.0%, so the hedging cost for euro-denominated assets is approximately 2.75%. The Australian dollar has a policy rate of 4.35%, resulting in a hedging cost of approximately 4.1%.

This cost is not fixed and fluctuates with changes in the interest rate environment. During periods like 2020-2021 when the U.S. policy rate was near zero, hedging costs also dropped below 0.5%. Conversely, during the rapid rate hikes of 2023-2024, hedging costs surged. It is important to consider not only "what the hedging cost is now" but also "how it might change in the future."

Hedged vs. Unhedged Return Comparison - Quantifying the Impact on Compound Growth

Let's use a concrete simulation to see how much hedging costs affect compound growth. Consider investing 10 million yen (about 10 man-yen) in a U.S. stock index (expected return of 7% per year) and holding it for 20 years. Assuming exchange rate movements are neutral (neither yen appreciation nor depreciation over the long term):

  • Unhedged (7% annual return): 10 million yen × (1.07)^20 ≈ 38.70 million yen
  • Hedged (7% − 4% hedging cost = 3% annual return): 10 million yen × (1.03)^20 ≈ 18.06 million yen
  • Difference: approximately 20.64 million yen

With a 4% annual hedging cost, a difference of over 20 million yen emerges over 20 years. This is because compound growth is significantly eroded by the hedging cost. A 7% annual return effectively dropping to 3% means the speed of the compound "snowball effect" is cut by more than half. Using the Rule of 72, the number of years to double your assets is approximately 10.3 years unhedged versus approximately 24 years hedged.

However, this comparison assumes neutral exchange rate movements. In reality, hedging is advantageous during periods of significant yen appreciation, while going unhedged is even more advantageous during yen depreciation. In 2022, when the rate moved from 115 yen to 150 yen per dollar, unhedged investors gained nearly 30% in returns from currency gains alone. On the other hand, during the 2008 Lehman crisis, the rate moved from 110 yen to 87 yen per dollar, and unhedged investors suffered currency losses on top of stock price declines.Related books on currency hedging and overseas investment provide detailed explanations of hedging cost drivers and practical decision criteria.

Decision Criteria for Hedging - Five Perspectives to Consider

Whether to hedge currency exposure cannot be determined uniformly; it should be judged based on each investor's circumstances. Let's examine this comprehensively from five perspectives.

First, investment horizon. For long-term investments of 15 years or more, exchange rate fluctuations tend to mean-revert over time, making an unhedged approach rational. Over the past 30 years, the yen-dollar rate has fluctuated between 75 and 160 yen, but over periods of 20 years or more, the impact of exchange rate movements on returns is limited compared to equity returns. For short-term investments of 5 years or less, however, exchange rate movements can dominate returns, increasing the value of considering hedging.

Second, the asset class of the investment. Equities have high expected returns (5-7% per year), so even after deducting hedging costs (4% per year), a positive return can be expected. However, foreign bonds have expected returns of only about 2-4% per year, and after deducting hedging costs, the effective return may be zero or negative. When investing in foreign bonds, the relationship with hedging costs should be carefully examined.

Third, the level of the interest rate differential. During periods when the Japan-U.S. rate differential is below 1% (such as the low-rate environment of 2020-2021), hedging costs are low and the disadvantage of hedging is minimal. Conversely, in the current environment where the differential exceeds 4%, hedging costs weigh heavily. Since rate differentials fluctuate with central bank policy, it is important not to assume that "today's rate differential will persist forever."

Fourth, currency diversification across the overall portfolio. If the majority of assets are yen-denominated (Japanese stocks, savings, real estate), holding foreign-currency assets unhedged provides currency diversification benefits. In scenarios where the Japanese economy stagnates and the yen weakens, foreign-currency assets compensate for the decline in yen-denominated assets. Conversely, if the proportion of foreign-currency assets is already high, hedging a portion to stabilize yen-denominated returns is also worth considering.

Fifth, psychological tolerance. Investors who experience strong stress from asset value fluctuations due to exchange rate movements can gain peace of mind by choosing hedged products. Reducing psychological burden is also an important factor for maintaining long-term investment. Some view the hedging cost as a "peace-of-mind premium."

How to Choose Between Hedged and Unhedged Investment Trusts - A Practical Guide

In practice, many investment trusts tracking the same index offer both "currency hedged" and "unhedged" versions. For example, the eMAXIS Slim Developed Country Bond Index comes in unhedged (management fee 0.154%) and hedged (management fee 0.176%) versions. The management fee difference is slight, but the hedging cost (the interest rate differential portion) is separately reflected in the fund's NAV, making the effective cost difference far larger than the management fee difference alone.

For developed-market equity funds, unhedged is the default choice for long-term investments (15 years or more). Hedging equity returns with an expected return of 7% in an environment where hedging costs 4% per year reduces the effective return to 3%, significantly diminishing compound growth. For developed-market bond funds, check the relationship between hedging costs and bond yields, and decide based on whether the post-hedge effective yield remains positive. In the current interest rate environment, hedged developed-market bonds often have an effective return near zero, and substituting with domestic bonds may be more rational.

Next Steps to Verify the Relationship Between Currency Hedging and Compound Growth

First, check whether the overseas investment trusts you currently hold are hedged or unhedged. Next, review the fund's management report to confirm the actual hedging cost. Many funds disclose an approximate hedging cost in their monthly reports. If the hedging cost accounts for more than half of the investment's expected return, it is worth considering switching to an unhedged version.

Use a compound interest calculator to simulate results at both the pre-hedging-cost rate and the post-hedging-cost rate. For example, comparing 20-year accumulation results at 7% annual return versus 3% (after deducting 4% hedging cost) makes it immediately clear how much hedging costs erode compound growth. Currency hedging is "insurance," and the key to maximizing compound growth in overseas investments is making a numbers-based judgment on whether the insurance premium is worth paying.