Investing overseas, whatever the asset, brings with it the reality of foreign currency exposure. Your return as an Australian investor comes from the performance of the asset in its local market and currency plus changes in the exchange rate versus the Australian dollar. Those changes can work against you or for you.
While some investors are happy to accept exchange rate fluctuations, for some it is an unwelcome source of volatility and uncertainty. That’s where currency hedging comes in. Most global bond funds are currency hedged, and many global share funds are also offered with hedged as well as unhedged options. This article explains how fund managers go about hedging exchange rate risk and the impact it has on how a portfolio performs.
There are two main ways of hedging foreign currency exposure in a managed fund: long term currency swaps or more commonly, foreign exchange forwards. This article focusses on the latter.
Hedging exchange rate risk
Let’s say a fund has A$100 to invest in a US$ asset. To do this it sells A$ and buys US$ to pay for the asset. At the time of writing the US$/A$ exchange rate was 77.5 cents, so the fund would buy US$77.50.
At the same time, the fund enters a contract to sell US$77.50 and buy back A$ at a date in the future, usually 3 to 12 months ahead. The exchange rate that is locked in will not be the same as today’s rate, but the difference is easy to calculate.
At present, the 3 month interest rate in the US is 0.2% pa, while in Australia it’s 2.2% pa. That’s an interest differential of 2.0% pa. So for a 3 month forward contract, the forward exchange rate is 0.5% lower (a quarter of 2.0%), which is 77.1 cents (I’ll explain why later).
Therefore, in addition to the US$ asset our fund also has a second asset, the forward currency contract. The combination means it doesn’t matter what the Australian dollar does over the next 3 months, the fund has locked in an exchange rate in 3 months’ time that differs from today’s rate by only 0.4 cents.
If over the next 3 months the A$ appreciates, say to 80 cents, then the value of the US asset to the fund will fall by 3.1% to A$96.88 (US$77.5 divided by 0.8). The US$ asset is worth less because the $A has appreciated. However, the forward contract will appreciate in value. In effect, the forward contract means that the fund could sell the US asset for cash and use the US dollars to buy A$ at the pre-agreed rate of 77.1 cents. For simplicity assume that the asset has not changed in value in US$ terms. Converting US$77.50 back to A$ at 77.1 cents means that the fund now has A$100.52 in it (77.5/77.1=1.005188).
The hedge has worked. Despite the rise in the A$ (fall in the US$), which would cause a 3.1% loss for an unhedged investment in US$, the hedged fund has experienced a return of +0.5%.
That figure is the interest differential between Australia and the US over the quarter. Some people are under the misconception that hedging costs you, but that’s not necessarily the case. Because the forward points are based on interest differentials, when you are hedging from a low rate country like the US to a higher yielding country like Australia, the hedged investor earns the positive interest differential.
Of course, if the A$ were to depreciate over the next 3 months – say to 70 cents – the hedge means the fund would not enjoy the rise in the A$ value of the US asset it has purchased. The unhedged value of the asset goes up to A$110.71, but the forward contract requires revaluation of the asset at 77.1 cents. Therefore, the fund value at the end of the period is once again A$100.52. Hedging means that you not only are protected against the downside that results from A$ appreciation, but you also miss out on the upside from currency depreciation. Your return is simply the change in foreign currency value of the asset (in this simple example that’s zero) and the forward points you locked in under your hedging contract.
Why the connection with interest rate differentials?
The way to hedge any risk is to have an offsetting liability against the asset that gives rise to the risk. An asset in US$ needs a liability in US$ to ensure no net exposure to changes in the value of the US$.
You could do this by borrowing money in US$, keeping your A$ in cash at home. You would pay the overseas interest rate on that debt, and earn the Australian interest rate on your cash.
A forward currency contract has the same economic impact. It creates a short term debt in US$ (you are obliged to make a payment when the contract expires) on which you pay the US short term interest rate; it also creates a short term asset in A$ (the currency you will be paid at expiry) on which you earn the Australian interest rate.
Rolling the hedging contract
In practice you don’t want to sell your foreign assets after only 3 months. Instead, the contract is closed out and settled based on the difference between the forward rate and the new spot rate after the initial 3 month period. In the example above where the A$ rises to 80 cents, the contract to sell US$77.50 at an exchange rate of 77.1 cents is closed out at a profit of A$3.64. The fund now holds the foreign asset revalued to A$96.88 and A$3.64 in cash – ie a portfolio value of $100.52.
In the situation of a fall in the A$, the end result is once again a portfolio valued in A$ at A$100.52. However, the fund needs to cover a loss on the forward contract, which at a 70 cent exchange rate amounts to A$10.20. In this case the fund would need to sell some of the US asset to get the cash to make this payment.
In reality, managed funds will keep a domestic bank account to have funds available to settle forward contracts. They also have a portfolio of foreign assets, which are paying income or have maturing assets that provide liquidity when needed.
Hedging through the use of forwards thus requires liquidity management, to ensure that the fund has cash available when needed to settle on forward contracts that go ‘out of the money’.
Final comment
A real world example may help to demonstrate how forward hedging plays out. Over the past 12 months the global government bond market has returned 4.1% measured in the local currency of each market. Unhedged, that is in A$ terms, global bonds delivered 12.2%, because the depreciating A$ has added 8.1% over the 4.1%. The same portfolio hedged into A$ has not enjoyed that currency appreciation, but has still returned 6.7%, well above the foreign currency outcome. The difference reflects the average +2.6% interest differential between Australia and global markets over the past year which is picked up via the hedging process.
Far from costing you, currency hedging for an Australian investor is a value-enhancing process.
Warren Bird is Executive Director of Uniting Financial Services, a division of the Uniting Church (NSW & ACT). He has 30 years’ experience in fixed income investing, including 16 years as Head of Fixed Interest at Colonial First State. He also serves as an Independent Member of the GESB Investment Committee. This article is general education and does not consider any investor’s personal circumstances.