Does currency diversification reduce risk?

Currency diversification means holding assets denominated in several currencies instead of only in one's home currency. Whether it reduces risk depends on how the currencies move — relative to each other, and above all relative to the investments themselves. Sometimes foreign currencies cushion losses; sometimes they add a second layer of volatility.

How currencies enter the risk

For a foreign investment, the variance of the return in euros combines the variance of the investment in its own currency, the variance of the currency, and their correlation:

\sigma_{\text{EUR}}^2 \approx \sigma_{\text{local}}^2 + \sigma_{\text{FX}}^2 + 2 \, \rho \, \sigma_{\text{local}} \, \sigma_{\text{FX}}

where $\rho$ is the correlation between the local return and the currency's move against the euro. If $\rho$ is negative — the foreign currency tends to rise when the investment falls — the currency reduces risk. If it is zero or positive, it adds risk.

A simple illustration

A US equity investment has a volatility of 16% in dollars, and the dollar moves against the euro with a volatility of 8%:

Correlation	Volatility in euros
+0.3	19.9%
0.0	17.9%
−0.3	15.6%

With a negative correlation, the unhedged investment is less volatile in euros than the stocks are in dollars. Historically, the US dollar has often strengthened against the euro during global stock market sell-offs, when investors seek safety — a negative correlation that has cushioned losses on US stocks for euro investors. Whether that pattern continues is not guaranteed.

When it helps and when it does not

Safe-haven currencies such as the US dollar, the Swiss franc and the Japanese yen have tended to rise in crises, which has made unhedged exposure to them a partial hedge for stock portfolios.
Commodity and emerging-market currencies have often fallen together with stock markets, adding to losses.
For bonds, whose own volatility is low, currency swings usually dominate and add risk; hedging is the common choice.

How to think about it

The spending currency matters. Money that will be spent in euros is safest in euros in the short run; long-term wealth can reasonably be held in several currencies.
A world equity portfolio is already currency-diversified, although mostly in US dollars.
Neither fully hedged nor fully unhedged is always best. Many investors hedge their bonds and leave their stocks unhedged, keeping the helpful part of currency diversification and removing the part that mainly adds volatility.

See these numbers for your own portfolio

Floreo works out every figure on this page from your own holdings — returns, risk, allocation, currencies — and the assistant explains them the way this page does. Import from your broker, or try it on the sample portfolio first.

Start Demo

The demo opens straight away on a sample portfolio — no account needed.