What is currency hedging?

Currency hedging means protecting a foreign investment against changes in exchange rates, so that its return in euros depends mainly on the investment's own performance. Private investors usually hedge through currency-hedged share classes of funds, often marked "EUR Hedged": the fund holds the same investments as the unhedged version, but continuously offsets its foreign currency exposure with forward contracts.

How it works

A hedged fund agrees today to exchange its foreign currency back into euros at a fixed rate in the future, typically renewing the contracts every month. The agreed forward price $F$ of the foreign currency differs from today's price $S$ by the difference between the two currencies' interest rates:

F = S \times \frac{1 + i_{\text{EUR}}}{1 + i_{\text{foreign}}}

where $S$ and $F$ are expressed in euros per unit of foreign currency. As a result, the return of a hedged investment is approximately:

R_{\text{hedged}} \approx R_{\text{local}} + (i_{\text{EUR}} - i_{\text{foreign}})

The currency's moves drop out. What remains is the investment's local return plus the interest rate difference — the cost of hedging when foreign rates are higher, and a gain when they are lower.

A simple illustration

A US equity fund returns 10% in dollars in a year in which the dollar falls 8% against the euro. US short-term rates are 4.5% and euro rates 2.5%, so hedging costs about 2 points:

	Dollar falls 8%	Dollar rises 8%
Unhedged share class	about +1.2%	about +18.8%
Hedged share class	about +8.0%	about +8.0%

The hedged share class delivers roughly the same result whatever the dollar does. The unhedged one can be much better or much worse.

When hedging makes sense

Bonds: currency swings can be as large as the bonds' own returns, so hedging foreign bonds usually lowers risk substantially. It is the standard choice for bond funds.
Stocks: the benefit is smaller. Currency moves add short-term volatility, but over long periods they have partly evened out, and some foreign currencies have tended to rise when stock markets fall, which softens losses.
Short horizons: money needed within a few years is more exposed to a single bad currency move.

Costs and limits

The interest rate difference is a cost whenever foreign rates are higher than euro rates, as US rates have been for much of the past decade.
Higher running costs: hedged share classes usually have a slightly higher TER, plus trading costs for renewing the contracts.
An imperfect hedge: the contracts are adjusted periodically, so currency moves within the month are only approximately offset.

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