Hedging Foreign Currency: 0%, 50% or 100%?

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Park
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Hedging Foreign Currency: 0%, 50% or 100%?

Post by Park » Sat Feb 27, 2016 12:31 pm

When one invests in foreign stocks, one is making two bets. One bet is the same as that of domestic stocks: foreign stocks will rise in value. You get a risk premium (equity risk premium) for taking that bet: the expected return is positive.

But there’s a second bet: that the foreign currency those stocks are denominated in will rise in value relative to your domestic currency. Unlike the first bet, there’s no risk premium associated with the second bet. Currency trading is a zero sum game: expected return is zero.

I’ve seen several different opinions, when it comes to the second bet.

One strategy is to accept the second bet. Foreign currency exposure decrease the correlation between domestic stocks and foreign stocks: in other words, it provides diversification. Swensen, in “Unconventional Success”, cites literature that foreign currency exposure up to 25% of one’s portfolio decreases volatility. A second argument for accepting the second bet is as follows. Siegel, in “Stocks For The Long Run”, states that

“In the long run, exchange rate movements are determined primarily by differences in inflation between countries, a phenomenon called purchasing power parity. Since equities are claims on real assets, their long-term returns have compensated investors for changes in inflation, and thus protected investors from exchange depreciation caused by higher inflation in the foreign countries.”

So if you’re a long term investor, currency hedging isn’t important.

Another strategy is to reject the second bet. There’s a risk that the second bet will go against you. But you’re not getting a risk premium for taking that risk. In other words, you’re taking on uncompensated risk. Also, if foreign currency exposure is more than 25% of your portfolio, Swensen states “the currency exposure constitutes a source of unwanted risk.” So it sounds like after that 25% mark, you’ve lost the diversification benefit of foreign currency.

To reject the second bet, you can currency hedge. The cost of currency hedging depends on the difference in short term interest rates between your country and the foreign country. In the developed world, the differences are small. Between developed and developing countries, the differences tend not to be small: developing countries tend to have higher interest rates. So currency hedging emerging market stocks tends to be expensive. Those who advocate currency hedging tend to recommend it for developed market stocks, but not for developing market stocks.

But currency hedging doesn’t always work. What is quoted below is from the following link by Canadian Couch Potato:

http://canadiancouchpotato.com/2015/02/ ... the-hedge/

“Currency-hedged index funds have a long history of high tracking error, which means they may not offer the protection investors expect. One reason is the cost involved in maintaining the forward contracts, although this is relatively small. The biggest factor is the volatility of currencies. Funds reset their currency hedges once a month, but big moves in the exchange rate frequently occur during the intervals. For that reason, hedging is not very precise. As Rob Carrick once described it: “Hedging is like playing hockey with a baseball bat. It can be done, but the results are clumsy.”

All of which means a currency-hedged ETF may not even protect you during a period of strong appreciation in the loonie. As Justin Bender found when he looked at the currency-hedged iShares Core S&P 500 (XSP), the strategy delivered no benefit at all from 2006 through 2011, even though the Canadian dollar rose more than 14% from about $0.86 to almost $0.99 during that period.

That’s why it’s not correct to say that the hedged-versus-unhedged decision should even out over the long term. Currency fluctuations might even out over the very long term, but unhedged funds will almost certainly track their benchmarks more precisely. Therefore, during periods when the Canadian dollar falls in value, you get the full benefit with an unhedged foreign equity ETF. But during periods when the loonie rises, the benefit of hedging may be muted, or even nonexistent.”

The above is written for Canadian investors, but it is relevant to any investor interested in foreign stocks.

Another argument that I’ve heard is that if you’re going to hedge, you should either 100% hedge long term or 0% hedge long term. Changing between hedged and unhedged is a bet on currency direction and that’s market timing.

Not everyone agrees on that. There are funds which switch between hedged and unhedged. Such funds are in some ways two funds combined; their goal is to make money from stocks and also to make money from currency trading.

I’m skeptical about making money from currency trading. But the following is from “Investment Philosophies” by Aswath Damodaran regarding market timing: “there seem to be strategies that work a high percentage of the time in the currency and commodity markets”. Managed futures funds do this. If you’re interest in how money is made from currency trading, the link below from Deutsche Bank discusses carry, momentum and value.

http://cbs.db.com/new/docs/dbCurrencyRe ... ch2009.pdf

In “Stocks For The Long Run”, Siegel makes the case that currency hedging may make more sense over the short term.

“Often, bad economic news for a country depresses both its stock market and currency value, and investors can avoid the latter by hedging. Furthermore, if it is the policy of the central bank to lower the currency value in order to stimulate exports and the economy, hedged investors can take advantage of the latter without suffering the losses of the former.”

Examples of the effects of currency risk on short term results of stocks are given in the Morningstar link below:

http://news.morningstar.com/articlenet/ ... ?id=741729

The three year annualized return of the Brazilian stock market in local currency is around a negative 7%; in US dollars, it’s around a negative 24%.

Another argument I’ve heard about currency hedging is as follows. In a financial crisis, there’s a flight to safety. This tends to benefit certain currencies, such as the US dollar, the euro and the Swiss franc; they tend to go up in value. Other currencies, such as the Australian dollar, Canadian dollar and emerging market currencies tend to go down in value. So if you’re an Australian investor during a financial crisis, stock markets may be going down worldwide. If such an investor has not currency hedged their US stock exposure, their US stock investments may decline less than a comparable investor who currency hedged their US stock exposure. There is a paper written about this; unfortunately, I can’t find the link.

The final and most recent argument I’ve heard about currency hedging is to hedge 50% of one’s foreign stock exposure. This comes from Investment IQ; it should be noted that Adam Patti (Investment IQ CEO) stated in a recent etf.com interview, that if you had a 20 year holding period, either completely hedged or unhedged would be OK. 50% hedging is for shorter periods.

The link below is Investment IQ’s paper on 50% currency hedging.

http://www.nylinvestments.com/polos/ME39a-071555414.pdf

The argument is made that regardless of whether one hedges or not, one is making a bet on currency. If the foreign currency loses in value relative to domestic currency, you lose if you’re unhedged. If the foreign currency gains in value relative to domestic currency, you lose if you’re hedged. An investor is unlikely to be successful at timing such bets, so why not take the middle course and hedge 50% of one’s foreign stock exposure?

The last paragraph was about return; this paragraph is about volatility. Hedging foreign stock exposure decreases volatility. However, a 50% hedge can decrease a good majority of the increased volatility. An example is given of a US investor having developed Europe stock exposure from 1985-2015. A 50% currency hedge decreased the additional volatility, due to foreign currency exposure, by 80%. And the case is made that foreign currency exposure can decrease volatility in some cases. For example, a US investor having Japanese stock exposure from 2004-2014 experienced decreased volatility if unhedged. Siegel, in “Stocks For The Long Run”, gives a similar example in emerging markets from 1988-2012.

Tylenol Jones
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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by Tylenol Jones » Sat Feb 27, 2016 1:10 pm

I'm not sure I'm following this. When I buy a stock, I own a company not the currency that it's listed in. For example, I want to buy a stock of company E in Euros. I buy 100 EUR for 110 USD and buy 10 shares of company E. Company appreciates by 10%, EUR goes down 10%, USD stays the same. I sell E for 100 EUR and then buy 121 USD. I don't see how EUR is relevant in all this. What remains is that company E went up 10%. What am I missing?

Johno
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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by Johno » Sat Feb 27, 2016 4:00 pm

Tylenol Jones wrote:I'm not sure I'm following this. When I buy a stock, I own a company not the currency that it's listed in. For example, I want to buy a stock of company E in Euros. I buy 100 EUR for 110 USD and buy 10 shares of company E. Company appreciates by 10%, EUR goes down 10%, USD stays the same. I sell E for 100 EUR and then buy 121 USD. I don't see how EUR is relevant in all this. What remains is that company E went up 10%. What am I missing?
The point of the OP, which is a nice summary, is that it's hard to be sure who is getting or not getting what about the FX risk of stocks whose listing unit of account isn't the same as the investor's home currency. I agree with your opening statement, which implies the fact that no stock is a promise to pay a certain number of units of a certain currency. GE stock isn't a promise to pay $'s, Siemen's stock isn't a promise to pay Euro's. And a stock certainly doesn't change from a promise to pay $'s to a promise to pay Euro's if a US company does a tax inversion and takes on the identity of a European domiciled/listed company it acquires. So it's clearly not completely correct at least to consider stocks using unit of account other than your own currency as being equivalent to bonds denominated in that currency.

However, the USD value of companies which do a lot of business in non-USD markets is likely to be sensitive to the foreign exchange value of the USD, and that's *more likely* to be relatively more true for companies with foreign domiciles and primary listing on exchanges using a non-USD unit of account than companies with primary listing on US exchanges using USD as unit of account. It's especially likely for relatively smaller companies.

So it's as the summary describes. You can find examples (of allocations, or countries, of periods of time) where no currency hedging or various degrees of currency hedging of stock unit of account gave lower volatility or not, higher return or not.

Practically speaking from perspective of many USD based investors, stocks which don't use USD as unit of account are a small enough % of total assets (a reference was mentioned saying 25%, but if it doesn't matter much at 25, how critical could it be at 30, etc?) that IMO no currency hedging of stocks is the generally good enough, simplest answer. Also suggested, once you realize 100% hedging is nearly never the right answer, and that the 'exact' answer tends to change with circumstances, then the fund you use (or perhaps you yourself) might tend to fall into trying to make money trading currencies as a sideline.

Also with reference to EM's, besides interest rate differential tending to be against the seller of EM currency, I believe a reasonable argument can be made that EM currencies should have positive expected return relative to DM currencies as PPP converges over time. There's still a currency risk factor, but it's not as clear it would be uncompensated over the long term. And again you tend to have to pay carry cost to hedge. If one were to hedge currency risk of EM stocks, I'd say just don't bother with EM stocks.

For investors from smaller countries for whom a close to global weight portfolio would be overwhelmingly in stocks of foreign companies, it's not as simple. It's not surprising if more is written and discussed about this from say a Canadian than US retail investor POV.
Last edited by Johno on Sat Feb 27, 2016 6:33 pm, edited 1 time in total.

rapporteur
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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by rapporteur » Sat Feb 27, 2016 6:31 pm

Dear Park,

Since about 2000 the Canadian currency has been an almost perfect "petrodollar" as the following article by Professor Werner Antweiler of the University of British Columbia attests:

The Canadian Petrodollar
http://wernerantweiler.ca/blog.php?item=2015-04-01

My calculations show the relationship has persisted at least through January 2016. On A log/log basis, the Canadian dollar (CAD) and the oil benchmark, West Texas Intermediate (WTI), show an R-squared of about 92 percent!

Of course, Canada is a bit unusual sectorally, with just three sectors dominating (Energy, Financials, Materials).

Incidentally, the University of BC website is by far the best source I know for long time series of FX exchange rates on a very broad range of currencies (and a few commodities such as WTI and gold)
http://fx.sauder.ubc.ca/

The Canadian petrodollar raises some odd and interesting possibilities, such as hedging the Canadian dollar with CFD contracts for WTI (sorry, USians are not allowed to purchase CFDs). The same can be achieved with futures or options, of course, including directly on the currency rather than WTI.

[CFDs for WTI - rather than FX - have the odd but interesting property that there is generally no broker charge for holding a position overnight - that is, no charge for an overnight "tomorrow swap" for a commodity, although there is a charge for holding an FX position (or FX CFD) overnight. In fact, the overnight broker rates for most FX pairs completely consumes any theoretical "carry" profit, except for oddball currency pairs. Interactive Brokers, for instance, charges 1.5% for positions under $100,000 on the mainstream currency pairs.]

As you pointed out, the CanadianCouchPotato website refers to articles that note the "procyclical" nature of the Canadian dollar and the relatively poor/coarse hedging job done by a number of Canadian mutual funds and ETFs. Accordingly, that website recommends that Canadians not hedge currency. Vanguard, in one of its white papers on currency hedging, also notes that, long-term, Canadians appear not to benefit from FX hedging their foreign investments.

I beg to differ.

My policy is a 'sliding hedge'. When the Canadian dollar is well above PPP (purchasing power parity as estimated by the OECD, even though its a crude approximation) I run naked and unhedged; as CAD approaches and falls below PPP I (progressively) hedge my US positions (e.g., now!). Even when I do hedge it's mostly my actual US holdings (e.g., MTUM, VOE, FNDA) rather than EAFE or emerging.

Some may criticise my USD hedging policy asserting currency hedging is (nearly) a zero-sum game. But, if that's the case, I' should be no worse off for pursuing any currency policy whatsoever, as long as I do so consistently and with low transaction costs :-)

Heck, I can hedge USD for under 30 basis points a year. With the collapse of oil (and correspondingly the Canadian petrodollar) since mid-2014 I've made a great deal of money on the FX side. If that's all just blind luck my response is Napoleon's quip, "I’d rather have lucky generals than good ones."

Regards,

Derek Tinnin
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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by Derek Tinnin » Sat Feb 27, 2016 7:05 pm

Hedging involves both positive and negative expected returns, so the academic approach would be to hedge the negative. In general (for US investors), if a country's nominal interest rate is lower than the US rate, it makes sense to hedge, and then leave the higher rates unhedged. So it's not a 0% or 50% or 100% question, it's an economic logic question.

Bernstein wrote about this back in 2000 here: http://www.efficientfrontier.com/ef/400/hedge400.htm.

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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by Artsdoctor » Sat Feb 27, 2016 10:06 pm

Park: Nice summary.

US investors haven't been happy with their international equity fund returns over the past few years. The market indices of developed countries haven't done that badly at home, but the returns we're seeing in our pocket books here in the US have not corresponded to the markets for the reasons you outlined. The dollar has risen so much that any returns in the foreign markets have been wiped out. There are hedged equity funds out there but their expenses are higher than unhedged funds, although their returns justified the expense recently. Whether to invest in a hedged equity fund or not is a personal decision and there's not a single right answer.

This is pertinent to the US investor in particular because we have a tremendous tendency for a home bias. We could theoretically have a 50/50 US/international allocation and justify it, but we're not just investing in the international companies, we're also making a play on currency as well. This is one of the reasons most people would hesitate to have such a large percentage of their equities in international funds.

Bonds, on the other hand, are much less likely to have much of a return in the home currency so hedging might make sense. This is Vanguard's argument. We've seen how much currency changes can affect international equity fund returns, but the currency would've killed international bond funds' returns if they weren't hedged.

From a Canadian perspective, they've done beautifully by investing in US companies, not because the indices have done well, but because the Canadian dollar has tanked. So that would be a reverse argument.

For the long run, I'd welcome some data on this, but it would seem that if you stay with a plan, you shouldn't be changing it. Trying to predict currency exchange is kind of like trying to predict interest rates or market returns.

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in_reality
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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by in_reality » Sat Feb 27, 2016 11:32 pm

Park wrote: But there’s a second bet: that the foreign currency those stocks are denominated in will rise in value relative to your domestic currency. Unlike the first bet, there’s no risk premium associated with the second bet. Currency trading is a zero sum game: expected return is zero.
Nice post Park!

Not to nitpick but I am not making a bet that the that foreign currency Int'l stocks are denominated in will rise in value relative to my domestic currency. If they stay the same, I am even. I am ok at even.
Derek Tinnin wrote:Hedging involves both positive and negative expected returns, so the academic approach would be to hedge the negative. In general (for US investors), if a country's nominal interest rate is lower than the US rate, it makes sense to hedge, and then leave the higher rates unhedged. So it's not a 0% or 50% or 100% question, it's an economic logic question.

Bernstein wrote about this back in 2000 here: http://www.efficientfrontier.com/ef/400/hedge400.htm.
Do understand that low nominal rates likely implies the currency will rise. What can make hedging profitable is often that the anticipated rise doesn't materialize, so current pricing is often an anomaly hedging can take advantage of.

Note though there is "no relationship between stock returns and forward currency rates" so the approach to hedge based on interest rates doesn't apply to stocks.
Artsdoctor wrote: For the long run, I'd welcome some data on this, but it would seem that if you stay with a plan, you shouldn't be changing it. Trying to predict currency exchange is kind of like trying to predict interest rates or market returns.
I agree. While there may be additional money to be made timing the market or picking individual stocks or betting on currency movement, it's unlikely mortals other than Odysseus will be able to draw the bow.

Just another reason to set and stay the course.

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whodidntante
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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by whodidntante » Sun Feb 28, 2016 3:07 am

It's costly to hedge, so I don't. This has me losing lately, but I think it's the right long-term strategy.

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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by laohan » Sun Feb 28, 2016 3:38 am

Fundamentally the equity w/ associated currency are one bet, especially for USD based investors. Capital is invested globally based on estimates of best returns, etc, and the "country" / location of the stock listing is given more importance than it should be. Here's an example :

US listing of a company that exports mainly to Mexico - if Mexican Peso goes down, that company will also go down (export revenues decrease in value).

Mexican listing of a similar company. If Mexican Peso goes down, the company is more likely to be relatively resilient, because on a local currency basis, the economics haven't changed (revenues in Peso are constant, price in Pesos is probably constant, revenues in USD is down, price in USD is probably down).

They are, roughly speaking, the same thing (indeed, one could be the ADR of the other). Why should they sustainably be priced differently?

As for the sources of nationality of revenue for companies, it's not easy to figure this out - take any large multinational like AAPL, and you'll see that even though it's a "US company", it's not really a US company at all; it's global. The smaller the market cap, the more local.

There could be a case to hedge your home currency, i.e. when you are investing, most people plan on spending that money eventually. Those expenses, if they are firmly rooted in local currency, may be worth positioning around.

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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by Park » Sun Feb 28, 2016 11:38 am

laohan wrote:Fundamentally the equity w/ associated currency are one bet, especially for USD based investors.
http://news.morningstar.com/articlenet/ ... ?id=741729

This is from the link above. In South African rand, the 3 year annualized return of the MSCI South African index has been around a positive 11% as of December 31, 2015. Assume an investor has $US to invest on January 1, 2013, and also wants $US from their investment on December 31, 2015. The investor decided to put their money for that three year period into the MSCI South African index. At the end of the three years, their annualized return in $US is around minus 9%.

How is that one bet? Am I missing something?

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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by Valuethinker » Sun Feb 28, 2016 12:11 pm

Park wrote:
laohan wrote:Fundamentally the equity w/ associated currency are one bet, especially for USD based investors.
http://news.morningstar.com/articlenet/ ... ?id=741729

This is from the link above. In South African rand, the 3 year annualized return of the MSCI South African index has been around a positive 11% as of December 31, 2015. Assume an investor has $US to invest on January 1, 2013, and also wants $US from their investment on December 31, 2015. The investor decided to put their money for that three year period into the MSCI South African index. At the end of the three years, their annualized return in $US is around minus 9%.

How is that one bet? Am I missing something?
Also companies tend to hedge transaction exposure, and may hedge asset exposure.

On the former, when they have an order in outside the home currency, they tend to hedge it back (ie for the period until when they expect to get paid) and ditto for suppliers (hedge forward buying costs).

On the latter, they may borrow in the external currency to hedge their assets in that currency. Eg if I am a Canadian co and I have a plant in the USA, I will at least hedge the balance sheet exposure-- borrow enough in USD to equal the assets. That removes volatility from the balance sheet due to XR fluctuations.

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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by ExpatChris » Sun Feb 28, 2016 12:58 pm

I find hedging 100% only interesting when I own a foreign bond in a non-base currency which is very volatile and rapidly moving against me. I have preestablished rules for this scenarion but also take the hedge off just as quickly as the volatility recedes.

patrick
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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by patrick » Sun Feb 28, 2016 2:26 pm

Park wrote:
laohan wrote:Fundamentally the equity w/ associated currency are one bet, especially for USD based investors.
http://news.morningstar.com/articlenet/ ... ?id=741729

This is from the link above. In South African rand, the 3 year annualized return of the MSCI South African index has been around a positive 11% as of December 31, 2015. Assume an investor has $US to invest on January 1, 2013, and also wants $US from their investment on December 31, 2015. The investor decided to put their money for that three year period into the MSCI South African index. At the end of the three years, their annualized return in $US is around minus 9%.

How is that one bet? Am I missing something?
What you care about is the changes in the US dollar price (along with dividends and US inflation). The US dollar price of a share of US stock is just the market price in US dollars of a certain fraction of that US company. Likewise, the US dollar price of a South African stock is just the market price in US dollars for a certain fraction of that South African company. Of course, the market price in US dollars of the South African share equals its market price in South African rand multiplied by the exchange rate, but that applies to US shares too!

Currency and US dollar stock price are only separate if you assume the price of the company (which can be quoted in any currency) is tied to a non-US currency. In practice, just about every large company is tied to multiple currencies. Large companies tend to have employees, suppliers, and customers in multiple countries, and thus often deal in multiple currencies. Even if the company doesn't directly deal with other countries, they'd still be indirectly affected to the extent they deal with world market prices. Companies probably do usually have more exposure to their home currency than others, but it's not absolute -- US companies don't do 100% in US dollars, nor do non-US companies do 0% in US dollars.

Some Chinese companies, including tech giants Alibaba and Baidu, have their stock listings in the US, traded in US dollars. Do you consider these companies as having currency risk?

Park
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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by Park » Sun Feb 28, 2016 4:22 pm

patrick wrote:
Park wrote:
laohan wrote:Fundamentally the equity w/ associated currency are one bet, especially for USD based investors.
http://news.morningstar.com/articlenet/ ... ?id=741729

This is from the link above. In South African rand, the 3 year annualized return of the MSCI South African index has been around a positive 11% as of December 31, 2015. Assume an investor has $US to invest on January 1, 2013, and also wants $US from their investment on December 31, 2015. The investor decided to put their money for that three year period into the MSCI South African index. At the end of the three years, their annualized return in $US is around minus 9%.

How is that one bet? Am I missing something?
What you care about is the changes in the US dollar price (along with dividends and US inflation). The US dollar price of a share of US stock is just the market price in US dollars of a certain fraction of that US company. Likewise, the US dollar price of a South African stock is just the market price in US dollars for a certain fraction of that South African company. Of course, the market price in US dollars of the South African share equals its market price in South African rand multiplied by the exchange rate, but that applies to US shares too!

Currency and US dollar stock price are only separate if you assume the price of the company (which can be quoted in any currency) is tied to a non-US currency. In practice, just about every large company is tied to multiple currencies. Large companies tend to have employees, suppliers, and customers in multiple countries, and thus often deal in multiple currencies. Even if the company doesn't directly deal with other countries, they'd still be indirectly affected to the extent they deal with world market prices. Companies probably do usually have more exposure to their home currency than others, but it's not absolute -- US companies don't do 100% in US dollars, nor do non-US companies do 0% in US dollars.

Some Chinese companies, including tech giants Alibaba and Baidu, have their stock listings in the US, traded in US dollars. Do you consider these companies as having currency risk?

I agree that large companies are tied to multiple currencies. I agree that companies often engage in currency hedging. I wouldn't be surprised if both apply to many of the companies on the MSCI South African index. Despite that, there was about a 20% difference between the return in South African rand and $US.

Let's assume I want to buy a South African stock, AngloGold Ashanti. It's listed on the Johannesburg Stock Exchange (JSE) and also as an ADR on the NYSE. I have $US to invest. Let's assume my brokerage account lets me trade on the JSE and the NYSE. I decide to trade on the JSE. I exchange my $US for rand, and buy the stock. Later, I sell the stock and exchange rand for $US. Or I could buy the ADR in $US, and sell the ADR in $US later. When it comes to buying and selling the ADR, the market has done the currency exchange for me. Regardless of how I buy the stock, my return will be the same.

Consider another scenario. I have South African rand, and buy the stock on the JSE. Three years later, I sell the stock on the JSE and keep the currency as South African rand. In this scenario, my return will be different than that of the preceding paragraph. Why the difference? Because in the preceding paragraph, I made a bet on AngloGold Ashanti, and I also made a second bet on the exchange rate between the US dollar and the South African rand.

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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by patrick » Sun Feb 28, 2016 6:32 pm

Park wrote:I agree that large companies are tied to multiple currencies. I agree that companies often engage in currency hedging. I wouldn't be surprised if both apply to many of the companies on the MSCI South African index. Despite that, there was about a 20% difference between the return in South African rand and $US.

Let's assume I want to buy a South African stock, AngloGold Ashanti. It's listed on the Johannesburg Stock Exchange (JSE) and also as an ADR on the NYSE. I have $US to invest. Let's assume my brokerage account lets me trade on the JSE and the NYSE. I decide to trade on the JSE. I exchange my $US for rand, and buy the stock. Later, I sell the stock and exchange rand for $US. Or I could buy the ADR in $US, and sell the ADR in $US later. When it comes to buying and selling the ADR, the market has done the currency exchange for me. Regardless of how I buy the stock, my return will be the same.

Consider another scenario. I have South African rand, and buy the stock on the JSE. Three years later, I sell the stock on the JSE and keep the currency as South African rand. In this scenario, my return will be different than that of the preceding paragraph. Why the difference? Because in the preceding paragraph, I made a bet on AngloGold Ashanti, and I also made a second bet on the exchange rate between the US dollar and the South African rand.
The difference is because you are measuring differently. In one case you are measuring in terms of US dollars, in the other in terms of rand. When you have shares of Anglogold Ashanti, you don't have dollars or rand, you have a fraction of the company, whose price will vary in any currency you quote it in, and will vary differently in different currencies if the exchange rate changes. It doesn't matter which currencies the companies deal in, nor does it matter how whether they are hedging. The same applies to US stocks -- their returns in US dollars are different from their returns in rand.

Perhaps you meant that the investor in your second scenario lives in South Africa and thus cares more about rand returns, while the investor in the first scenario is in the US and cares more about US returns. If the rand falls against the dollar, the South African investor would be happier about the returns of Anglogold Ashanti than the US investor, assuming that South Africa doesn't also have significantly higher inflation than the US. But in that case, the South African investor would also be happier with US stocks returns, because (assuming the investor does not hedge) the South African investor's US investments (when measured in rand) are better than the US investor's US investments (when measured in dollars).

The investment in the home country is really only safer to the extent that home country stock prices are more linked to the home currency than foreign stocks. I already gave reasons this would happen to some extent but not completely.

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in_reality
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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by in_reality » Sun Feb 28, 2016 7:36 pm

Park wrote: Let's assume I want to buy a South African stock, AngloGold Ashanti. It's listed on the Johannesburg Stock Exchange (JSE) and also as an ADR on the NYSE. I have $US to invest. Let's assume my brokerage account lets me trade on the JSE and the NYSE. I decide to trade on the JSE. I exchange my $US for rand, and buy the stock. Later, I sell the stock and exchange rand for $US. Or I could buy the ADR in $US, and sell the ADR in $US later. When it comes to buying and selling the ADR, the market has done the currency exchange for me. Regardless of how I buy the stock, my return will be the same.

Consider another scenario. I have South African rand, and buy the stock on the JSE. Three years later, I sell the stock on the JSE and keep the currency as South African rand. In this scenario, my return will be different than that of the preceding paragraph. Why the difference? Because in the preceding paragraph, I made a bet on AngloGold Ashanti, and I also made a second bet on the exchange rate between the US dollar and the South African rand.
Convert the returns from the second paragraph into the currency of the first (USD). Now your returns are the same (minus conversion costs).
patrick wrote: Some Chinese companies, including tech giants Alibaba and Baidu, have their stock listings in the US, traded in US dollars. Do you consider these companies as having currency risk?
Of course they do. If their profits in Yuan are up 25% but the currency down 50%, your dividend in USD is going to be less than last year (despite their increased profitability).

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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by Park » Thu Mar 10, 2016 12:42 am

http://www.kiplinger.com/article/invest ... hedge.html

Jeremy Siegel:

"To best insulate your stock portfolio from inflation, you must diversify internationally. If inflation kicks into overdrive, the dollar will fall and foreign stocks will act as an automatic hedge as money invested in foreign currencies is translated into more dollars back home."

magneto
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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by magneto » Thu Mar 10, 2016 7:04 am

Generally when seeking out the elusive Rebalancing Bonuses, the investor will hold volatile assets together with low volatility assets as a counterweight.

So where Stocks are the volatile element of the portfolio, suggest the more volatile are the stocks the better the end result. :!:
The additional level of currency volatility should therefore be welcomed with open arms, as an aid in the search for those Rebalancing Bonuses. :?:

No Volatility = No Opportunity :?:
'There is a tide in the affairs of men ...', Brutus (Market Timer)

Ma15
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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by Ma15 » Sat Mar 26, 2016 10:29 pm

.....
Last edited by Ma15 on Sun Apr 03, 2016 4:27 am, edited 1 time in total.

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Watty
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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by Watty » Sat Mar 26, 2016 11:49 pm

There is a lot a talk about "Foreign Currency" but that is really referring to a pretty diverse basket of currencies and just like other investments diversification will help you from being hurt too badly if just one of the specific currencies goes down. For example; Euros, UK Pounds, Japanese Yen, China Yuan, etc.

There could be a dozen or more currencies involved each of the individual currencies would be a very small percentage a typical US investors portfolio.

I would go with 0% hedging if you are a somewhat typical US investor.

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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by Clive » Sun Mar 27, 2016 4:02 am

0% hedging is lower cost, and potentially safer.

Consider a asset that has a 4% arithmetic (yearly average) with 20% standard deviation. Pythagorean CAGR (geometric) approximation = 2.1%, which is comparable to the inflation rate targeted by the Fed/Bank of England.

Image

Add another asset also with 4% arithmetic, 20% standard deviation, but that is inversely correlated to the first asset, and a 50/50 blend of the two yields a 4% geometric with 0% standard deviation

Image

Despite both assets individually providing a inflation pacing return, combined and rebalanced the reward is boosted (to nearly 2% real) with lower risk (0% standard deviation in the case of perfectly inversely correlated assets). [images and formula courtesy of Gummy (Peter Ponzo)]

I'm (early) retired. Owning a (UK GBP) home means that all 'rent' is pre-paid (liability matched. Could sell home, invest in stocks and hope that that covered the rent and house price appreciation, but that's unnecessary risk). Holding US stocks (USD) and gold (global currency) and each of house prices, share price (only, excluding dividends) and gold might see all three individually broadly pacing inflation - but in a volatile manner, and potentially with low/inverse correlations such that a three-way of those assets, periodically rebalanced, outpaces inflation (2.1% annualised real since 1896 excluding stock dividends and imputed rent benefit). And then there's the added benefit of imputed rent and dividends thrown in on top (uplifts total return to 5% annualised real return since 1896, or 3.5% if include stock dividends but exclude imputed rent i.e. disposable 'income' after having paid 'rent'). Risk of total loss is also reduced - if for instance a WW2 bomb destroyed a London home (uninsured (act of war) loss), then a -33% loss was recoverable. Setting 1940 house value to -100% for instance lowered the annualised real total return since 1896 down from 5% to 4.7%.

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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by Bud » Sun Mar 27, 2016 6:35 am

Living in a foreign country and investing in a couple of countries, hedging is of interest to me.

If you hedge, you take away the currency risk. As someone mentioned, you may "lose" out if exchange rates fluctuate higher, but the reason to hedge is to reduce this risk. This is often why business normally hedge their deals or negotiate in US$.

However, I did quite a bit of research on predicting currency fluctuations about 15 years and there is NO way to accurately predict currency exchange rates - not at any level. Changes of government, exports, imports, petro, rising GNP, etc, etc. Unfortunately I did not keep my research but all of it was available in academic papers via the internet.

So hedging a foreign investment or leaving a foreign investment unhedged are two different investments. As one poster stated, hedging has a cost and you need to consider that cost as part of your investment.

All the best...

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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by Tanelorn » Sun Mar 27, 2016 7:33 am

Park wrote:the cost of currency hedging depends on the difference in short term interest rates between your country and the foreign country. In the developed world, the differences are small. Between developed and developing countries, the differences tend not to be small: developing countries tend to have higher interest rates. So currency hedging emerging market stocks tends to be expensive. Those who advocate currency hedging tend to recommend it for developed market stocks, but not for developing market stocks.

But currency hedging doesn’t always work. What is quoted below is from the following link by Canadian Couch Potato:

http://canadiancouchpotato.com/2015/02/ ... the-hedge/

“Currency-hedged index funds have a long history of high tracking error, which means they may not offer the protection investors expect. One reason is the cost involved in maintaining the forward contracts, although this is relatively small. The biggest factor is the volatility of currencies. Funds reset their currency hedges once a month, but big moves in the exchange rate frequently occur during the intervals. For that reason, hedging is not very precise. As Rob Carrick once described it: “Hedging is like playing hockey with a baseball bat. It can be done, but the results are clumsy.”
I don't know why people say currencies are expensive to hedge. FX is the largest most liquid market in the world and the spreads are tiny. It's true that EM currencies are slightly more expensive, but for an index portfolio, I would think this wouldn't be a big effect since you only have significant exposure to large EM countries and the FX markets for those countries are likely to be reasonably cheap to trade. In addition, the capital required for FX hedging contracts is almost nothing, so it's not like any meaningful amount of your stock investment would need to be diverted to hedging capital.

I think some people confuse the "cost" of hedging with the interest rate you pay when you're short a country like Australia or an EM country with a high interest rate. Yes, you pay the rate differential between the two currencies, say USD/AUD, but that expected difference is already priced into the futures or forward contracts so it's only an expense if the rates move the wrong way against you (and it's a savings if they move the right way).

The comment about tracking error also seems ill-conceived. Just because FX rates are volatile sometimes doesn't mean that the volatility you see is "tracking error". In almost all cases, once a hedge is put in place, it doesn't need to be meaningfully adjusted. It sounds like the guy saying these are clumsy is either not doing it well or is referring to a time period when the stock-FX correlation was such that it was better not to be hedged and hence the "tracking error" vs an unhedged fund looked high. But the correct benchmark for a hedged equity fund would not be an unhedged fund, so it's hard to see why FX movements would cause volatility when viewed in the hedged currency.
Another argument I’ve heard about currency hedging is as follows. In a financial crisis, there’s a flight to safety. This tends to benefit certain currencies, such as the US dollar, the euro and the Swiss franc; they tend to go up in value. Other currencies, such as the Australian dollar, Canadian dollar and emerging market currencies tend to go down in value. So if you’re an Australian investor during a financial crisis, stock markets may be going down worldwide. If such an investor has not currency hedged their US stock exposure, their US stock investments may decline less than a comparable investor who currency hedged their US stock exposure. There is a paper written about this; unfortunately, I can’t find the link.
This is a good point for investors of different countries to consider. If you're a "safe haven" currency denominated investor, you should more strongly consider hedging since when your risky foreign stock investments sell off in a global downturn (as opposed to a country-specific downturn), their currencies are also likely to weaken relative to your home currency for a double whammy against you (as many USD investors in EM funds have seen recently). OTOH, if you're based in a more traditionally risky currency, you probably want to hedge less or none at all since the correlation is more favorable. Investments in a safe country's stocks are likely to benefit from currency appreciation in a downturn, so that will help offset the equity risk, while investments in a different risky country's stocks are likely to suffer similarly to yours from a currency perspective so it's probably a wash.

columbia
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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by columbia » Sun Mar 27, 2016 8:18 am

Do any companies offer a hedged global fund (for one stop shopping)?

I see that this exists:

iShares Currency Hedged MSCI EAFE ETF
http://www.morningstar.com/etfs/ARCX/HEFA/quote.html

Ma15
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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by Ma15 » Sun Apr 03, 2016 4:24 am

.....

Park
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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by Park » Sun Jul 03, 2016 7:57 am

https://personal.vanguard.com/pdf/icriecr.pdf

"Investments in foreign markets are exposed to
fluctuations in foreign exchange rates. Figure 9
illustrates that currency fluctuations have periodically
added to or subtracted from the return for U.S.
investors of international investments. For example,
currency movements subtracted 17% from the
12-month returns of international stocks in 1984
and then added 35% in 1986.2
Although currency movements tend to be
unpredictable and can be large, they have historically
been uncorrelated to movements in stock prices.3
As a result, over time, currency movements have
helped to reduce the correlation between non-U.S.
equities and U.S. equities, thus contributing to the
diversification benefits of foreign holdings. For
example, since 1970, the correlation of foreign
stocks denominated in their local currency to
U.S. stocks was 0.70, nearly 10 points higher
than the correlation of foreign stocks denominated
in U.S. dollars to U.S. stocks. However, currency
movements also increased the volatility of non-U.S.
equities by approximately 2.5 percentage points
from 1970 through 2011 (from 14.9% to 17.4%)."

magneto
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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by magneto » Sun Jul 03, 2016 11:25 am

May depend on the Investor's view of Volatility and the Investor's working methods.

Does Volatility = Risk, as many academics propose?

or does Volatility = Opportunity? (the opportunity to rebalance to advantage)

Currency Risk is another layer of Risk or Opportunity, dependent on the investor's viewpoint.
Is the investor seeking more or less Volatility (oppportunites to rebalance)?

Over the past six trading days, Investors here in the UK will have beeen most grateful if their International exposure was unhedged, as £Sterling plummeted!

Unfortunately we cannot rely on currencies to Mean Revert.
Currencies only seem to Revert to Mean to a degree in the short to medium term.
Longer term; trends upwards or downwards can and do persist.

However where we might not want Volatility is on the Fixed Income side!
Hedging would then seem to be mandatory?

No easy answers. :(
'There is a tide in the affairs of men ...', Brutus (Market Timer)

Park
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Re: Hedging Foreign Currency: 0%, 50% or 100%?

Post by Park » Sun Jul 08, 2018 10:29 am

In his booklet "Deep Risk", William Bernstein makes the point that international stocks can provide protection against inflation and deflation. The exception would be if inflation or deflation are world wide in nature, and worse outside one's country of origin. Currency hedging would negate that protection.

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