Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 90

Currency hedging for international equity portfolios

With recent volatility in the value of the Australian dollar (AUD), investor attention is again drawn to the topic of currency hedging. This article looks at the impact of currency on international equity investments for an Australian investor and explores some of the factors that influence the decision to hedge currency exposure.

The impact of currency risk

Currency risk is typically a significant proportion of the total risk of an unhedged international equity portfolio which can have a large impact on returns. For example, over the 12 months to February 2009, unhedged investors were about 20% better off than their hedged counterparts, while over the 12 months to March 2010 they were about 40% worse off (Chart 1).

Over the long term, the difference between hedged and unhedged returns is less dramatic because currencies have a tendency to fluctuate around a long-term average. However, hedged investors have been better off by an average of 1.2% per annum (ignoring hedging and carry costs) over the 26 years since 1988. The hedged portfolio has had the added benefit of lower volatility (on average) than the unhedged (14.0% vs 14.8%).

The relationship between currency and equity returns

In the aftermath of the GFC, the volatility of a currency-hedged All Country World Index (ACWI) portfolio rose above that of an AUD unhedged ACWI portfolio; an unusual situation that persisted until mid-2013 (Chart 2).

In other words, it became more ‘risky’ for an investor to hedge their AUD currency exposure than to not hedge during this period. This somewhat counter-intuitive phenomenon was the result of a significant increase in correlation between the AUD currency basket and international equity returns (as shown in Chart 3). During this period the currency exposure of an AUD ACWI equity portfolio became a diversifying position. From a ‘total risk’ perspective it was hard to justify hedging currency risk during this period because it increased overall risk. However correlations have now returned to more normal levels and hedged volatility has again dropped below unhedged on a trailing 12 month measure.

This event clearly illustrates that relationships between financial assets are not guaranteed to remain stable and any assumptions that are made as part of the investment process need to be monitored.

Optimal currency hedge ratios

To illustrate the impact of this correlation change we calculate the optimal currency hedge ratio for an investor trying to minimise the total volatility of their global equity portfolio by adjusting the currency hedge (Chart 4). The grey lines show the total risk of equity and currency combined, while the light blue line shows the currency risk in isolation. The optimal total-risk hedge level will be the lowest point on the grey line. We see that in June 2012 the optimal total-risk position was to leave AUD exposure completely unhedged, while the current optimal position is to be roughly 50% hedged. A hedge level of 50% implies that half of the total currency exposure is hedged. Of course if your objective is to eliminate as much currency risk as possible then the optimal choice is always to be fully hedged, regardless of total portfolio volatility.

Hedging returns

Some investors may not be aware that there is a return associated with a currency hedge that is independent of currency and market movements. This return is the ‘cost of carry’ (or a ‘return of carry’) which reflects interest rate differential between the base currency and foreign currency exposures which are being hedged; it is priced into the currency ‘forward points’. A currency hedge effectively earns the domestic interest rate and pays the foreign rate; for AUD investors this has historically provided a benefit, as illustrated in Chart 5. This benefit would reduce if, for example, US interest rates were to rise while AUD rates remain on hold. You will notice there is variability in the hedging return, which means that it is not ‘risk free’, however the variation in forward returns is typically much lower than the variation in the currency returns which are being hedged.

Why hedge currency exposure

So does it make sense to hedge currency exposure? There are several reasons investors might want to consider currency hedging, including:

  • Prior to 2008, hedging currency exposure reduced the total volatility of an AUD based international equity portfolio. Now that correlations have returned to more historically normal levels this may be the case again going forward (though of course this is not guaranteed).
  • If a view is held on the AUD, this can be reflected in the level of currency hedge. If there is no view on the currency then arguably it is unwise to take exposure to a source of risk from which you have no expectation of return and therefore we would argue that currency hedging should be considered in this scenario too.
  • Historically there has been a carry benefit to hedging the AUD due to the prevailing interest rates. As long as interest rates in Australia are higher than the weighted average rates of international markets, then this may remain the case.

Summary

At Realindex we always encourage investors to take a long-term view on their investment. If an investor holds a long term view on the AUD then it is sensible to implement a hedging strategy that reflects that view (be it hedged or unhedged), and stick to it. If no view is held on the currency, then there are still very valid reasons to consider hedging currency exposure. In either case, it is important to ensure that any performance benchmark is aligned with the strategic hedging decision, and that the risk and cost implications of this decision are fully considered.

 

Scott Hamilton is a Senior Quantitative Analyst with Realindex Investments. This article is for general educational purposes and readers should seek their own professional advice.

 

2 Comments
Capital Markets Guy
December 01, 2014

Hi Scott,

Thanks for this work. Could you help me to understand were you got your hedged ACWI return series from (I can't see one published on Bloomberg by MSCI) as I am trying to replicate these charts and are unable to.

When I look at similar charts for the MSCI Developed Markets index, for example, it looks like unhedged returns are generally less volatile than hedged returns (the opposite of what you find here).

Also, I found it interesting that you say that hedged investors receive the interest rate differential between the two countries involved - my understanding was that both hedged and unhedged returns receive the interest rate differential, but only the unhedged returns receive the effect of changes in exchange rates (with the difference between the two return series being equal to the so-called "currency surprise" effect).

Thanks again for sharing.

Scott Hamilton
December 01, 2014

Hi Capital Markets Guy.

When hedging with forwards you effectively lock in the interest rate differential every time you set the hedge because this is built into the forward rate. You would probably want to hedge at the prevailing spot rate but you can't, the best you can do is the forward rate which has the interest rate differential baked into it.

As for the ACWI data... I cheated and used "local currency" index returns as a "perfectly hedged" proxy (because I wanted to go back as far as possible with daily data). I haven't looked at the Developed World data but I would have expected it to display similar pattern. Unhedged volatility has definitely been lower than "currency neutral" volatility since 2008, however before that it seems to be predominantly the other way round.

Hope this makes sense.

Regards

Scott

 

Leave a Comment:

RELATED ARTICLES

Does currency hedging provide an edge?

To hedge or not to hedge?

Currency risk deserves more than a coin toss

banner

Most viewed in recent weeks

16 ASX stocks to buy and hold forever, updated

This time last year, I highlighted 16 ASX stocks that investors could own indefinitely. One year on, I look at whether there should be any changes to the list of stocks as well as which companies are worth buying now. 

2025-26 super thresholds – key changes and implications

The ABS recently released figures which are used to determine key superannuation rates and thresholds that will apply from 1 July 2025. This outlines the rates and thresholds that are changing and those that aren’t.  

Is Gen X ready for retirement?

With the arrival of the new year, the first members of ‘Generation X’ turned 60, marking the start of the MTV generation’s collective journey towards retirement. Are Gen Xers and our retirement system ready for the transition?

Why the $5.4 trillion wealth transfer is a generational tragedy

The intergenerational wealth transfer, largely driven by a housing boom, exacerbates economic inequality, stifles productivity, and impedes social mobility. Solutions lie in addressing the housing problem, not taxing wealth.

What Warren Buffett isn’t saying speaks volumes

Warren Buffett's annual shareholder letter has been fixture for avid investors for decades. In his latest letter, Buffett is reticent on many key topics, but his actions rather than words are sending clear signals to investors.

The 2025 Australian Federal election – implications for investors

With an election due by 17 May, we are effectively in campaign mode with the Government announcing numerous spending promises since January and the Coalition often matching them. Here's what the election means for investors.

Latest Updates

World's largest asset manager wants to revolutionise your portfolio

Larry Fink is one of the smartest people in the finance industry. In his latest shareholder letter, the Blackrock CEO outlines his quest to become the biggest player in private assets and upend investor portfolios.

Economy

Australia's economic report card heading into the polls

Our economy grew by a nominal rate of 7% per annum from 2017 to 2024, but it benefited from the largesse of fiscal and monetary policies, both of which are now fading. We need a new, credible economic growth agenda.

Preference votes matter

If the recent polls are anything to go by, we are headed for a hung parliament at the upcoming federal election. So more than ever, Australians need to give serious consideration to their preference votes.

SMSF strategies

Meg on SMSFs: Tips for the last member standing

It’s common for people as they age to seek more help in running their SMSF if their capacity declines. An alternate director may be a great solution for someone just planning for short-term help in the meantime.

Wilson Asset Management on markets and its new income fund

In this interview, Matthew Haupt from Wilson Asset Management discusses his outloook for the ASX, sectors such as REITs that he likes, and his firm's launch of a new income-oriented listed investment company.  

Planning

‘Life expectancy’ – and why I don’t like the expression

Life expectancy isn't just a number - it's a concept that changes with survival rates over time. This article breaks down how age, survival, and societal factors shape our understanding of life expectancy, especially post-Covid. 

The shine is back on gold, and gold miners

Gold mining stocks outperformed in 2024 and are expected to do well in 2025. At this point in the rally, it's worth considering what has driven gold prices higher and why miners could still have some catching up to do.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.