What is Currency Hedging?
Currency hedging is the practice of using financial instruments to offset the risk of adverse exchange rate movements on international investments. When a Japanese investor buys US stocks, returns depend on both stock performance and the USD/JPY exchange rate. A hedged fund uses forward contracts to lock in exchange rates, isolating the investment return from currency fluctuations.
Hedged vs. Unhedged Investing
Currency-hedged funds eliminate exchange rate risk but incur hedging costs, typically 0.1-0.5% annually depending on the interest rate differential between currencies. Unhedged funds accept currency risk but benefit when the foreign currency strengthens. For bonds, hedging is generally recommended because currency volatility can overwhelm the modest returns of fixed income. For equities, the decision is less clear-cut since currency movements tend to average out over long holding periods.
Key Considerations
The optimal hedging ratio depends on your investment horizon and risk tolerance. Short-term investors benefit more from hedging because currency movements can dominate returns over months. Long-term investors may prefer partial hedging or no hedging, as currency diversification itself provides a risk reduction benefit. Many financial advisors recommend hedging 50% of foreign currency exposure as a balanced approach.