What Is Currency Risk?
Currency risk is the exposure created when an investment is denominated in a currency other than the one an investor spends. It affects returns independently of how the underlying asset performs, and for bonds it typically contributes more variation than the bonds themselves.
Hold an asset priced in another currency and you hold two things. The asset is the one you chose; the currency came with it, and for many portfolios it is the larger of the two.
How it works
Your return has two components. What the asset did in its own currency, and what that currency did against yours.
They combine multiplicatively. An asset up 10% in a currency that fell 10% leaves you close to unchanged, and neither fact tells you anything about the other.
And the currency component has no expected return. Over long periods, exchange rates between developed economies neither reliably rise nor fall — you are adding variation without adding expected reward.
Why it matters more for bonds than equities
Currency movement is large relative to bond returns. Bonds produce single-digit returns with modest variation, and exchange rates routinely move by more than that in a year.
So an unhedged foreign bond fund is mostly a currency position. The thing described on the label contributes less to the outcome than the thing not mentioned on it.
Equities are different. Their own variation is large enough that currency is a smaller proportion of the total, and companies often have natural offsets through foreign earnings.
A worked example
A foreign bond fund returns 4% in its local currency. That currency falls 7% against yours.
Your return is about −3%. The bonds did what they were supposed to and you lost money, and nothing about the fixed income analysis was wrong.
Run it the other way and the currency gains 7%, producing an 11% return that had nothing to do with the bonds either.
Neither outcome was a bond decision. The variation came almost entirely from an exposure that was never part of anybody’s investment case.
What hedging actually costs
Not a fee, but the interest rate difference. Hedging uses forward contracts, and the forward rate is set by the gap between the two countries’ interest rates.
Hedging a currency with lower interest rates than yours earns you the difference. Hedging one with higher rates costs you it, and that cost can be several percent a year.
Which is not a charge anybody levies. It is the carry arithmetic described in forward contract, enforced by arbitrage, and it applies whichever direction the exchange rate subsequently moves.
So hedging is close to free between similar economies and expensive against high-rate currencies — and the high-rate cases are frequently exactly the ones where the currency risk is largest.
The original data
On this site’s shared series the median bar range is 0.493, the ninetieth percentile 1.101 and the largest single bar 2.338, with direction runs averaging 2.01 bars and a longest of 11.
Currency moves have a similar shape and a different persistence. Exchange rates trend for years and then reverse over years, which means a horizon short enough to care about can be entirely dominated by one direction.
And this site’s fee measurement sets the scale for the hedging decision: 75 basis points costs 20.2% of a thirty-year balance. A hedging carry cost of two or three percent a year is far larger than that, which is why the choice deserves more attention than a fund fee usually gets.
What most people should actually do
Hedge foreign bonds. The currency variation swamps the asset’s, and removing it leaves you with the exposure you wanted. This is the least controversial view in the area.
Equities are genuinely arguable. Currency provides some diversification against domestic shocks, the hedging cost is real, and reasonable people reach opposite conclusions.
And spending currency is what matters. Somebody who will retire abroad has a different natural currency from their passport, and the relevant question is what they will eventually buy things in.
The one clear error is not deciding. An unhedged position is a currency position, whether or not anybody framed it that way, and the default in most funds is unhedged.
The three exposures companies distinguish
Transaction exposure is a known future payment or receipt in a foreign currency, which is specific, datable and straightforward to hedge with a forward.
Translation exposure arises when foreign subsidiaries are consolidated into group accounts, and it changes reported figures without any cash moving.
Economic exposure is the effect of exchange rates on competitiveness — a domestic manufacturer can be damaged by a strong home currency even with no foreign transactions at all.
The third is the largest and the least hedgeable. It has no defined amount or date, so there is nothing precise to hedge, and companies address it through where they locate production rather than through financial contracts.
When it fails
The characteristic failure is a diversification argument doing the opposite. An investor adds foreign holdings to reduce dependence on their home market, leaves the currency exposure unhedged, and finds the portfolio moves more rather than less. The assets diversified and the currency did not — it added a second volatile factor with no expected return attached. What was framed as a risk-reduction decision increased total variation, and the additional variation is uncompensated by construction.
A second failure is holding unhedged foreign bonds for income, where the currency dominates the outcome.
A third is assuming hedging is free. The carry can be several percent a year against a high-rate currency.
A fourth is chasing a high yield abroad, which frequently reflects expected currency depreciation rather than a better deal.
And a fifth is not choosing. Unhedged is a position, and it is the one most funds default to.
Related
Country risk covers the wider set of exposures crossing a border brings. Market risk covers the asset exposure this sits alongside. And basis swap covers the cross-currency funding market that prices hedging.
Buying a foreign bond fund unhedged means taking two positions: one on the bonds and one on the currency. The second is usually larger than the first, nobody chose it deliberately, and it is not expected to earn anything.
— Michael Whitman
This page is educational, not financial advice. Test every idea on your own charts before risking money.