Currency Hedging for Global Portfolios

A US pension fund buys a basket of German equities. It now owns two separate bets: the performance of German companies, and the euro against the dollar. The equities are the bet the fund actually wanted to make. The currency exposure came along for free, unasked, and can easily swing the total return by more than the stocks did. Currency hedging is the practice of separating those two bets — using forwards to neutralize the currency piece so the portfolio's return reflects the foreign asset alone, not the exchange rate along the way.

How the hedge is built

A fund sells the foreign currency forward in an amount roughly equal to the foreign asset's value, so a decline in that currency is offset by a gain on the forward position:

$$R_{hedged} \approx R_{asset, local} + (r_{home} - r_{foreign})$$

In words: the hedged return is approximately the asset's return in its own local currency, plus or minus the interest-rate gap between the home and foreign currency — the same forward points from covered interest parity, now showing up as a return drag or boost rather than a funding cost. Hedging doesn't just remove currency risk; it also swaps out the currency's expected return for the interest-rate differential, which can be a headwind if the home currency happens to pay less than the foreign one.

Worked example

A US fund holds $100 million of Japanese equities, up 12% in yen terms over the year. Meanwhile the yen weakens 10% against the dollar. Unhedged, the fund's dollar return is roughly $1.12 \times 0.90 - 1 \approx 0.8\%$ — the currency move erased almost the entire equity gain. Had the fund sold yen forward on the position at the start of the year, it would have captured close to the full 12% local return (adjusted for the small US-Japan rate differential embedded in the forward points), instead of watching a genuinely good stock-picking year turn into a near-flat one purely on currency.

What this means in practice

Whether to hedge depends on what the currency is doing to the rest of the portfolio: for bonds, currency risk is often large relative to the underlying return, so hedging is close to standard practice; for equities, unhedged currency exposure has historically added diversification in some crises (a weak home currency coinciding with weak home markets) and hurt in others, so funds vary widely, and many run a partial hedge ratio rather than 0% or 100%.