$ Currency Risk A BigFuture Guide
Many people would invest much more overseas if it weren t for the problem of currency risk. But what is currency risk and can we manage it? When we invest overseas we purchase an asset in a currency other than our local currency (the Australian dollar). This poses two problems. For an individual it is still difficult to buy foreign currency, and the margins taken by banks are large. Secondly, the value of the local currency changes all the time and an investor could experience a foreign exchange loss. First, for individuals for small investments purchasing small amounts of currency is expensive. Bank margins frequently take a 2% margin, if not more. It is also fiddly. As an individual, unless you have a foreign bank account, you have to purchase foreign currency to be timed when the purchase of the foreign asset is settled. You need the exact right amount of foreign currency after any bank fees to be delivered on an exact day. This is why most retail investors do not purchase individual securities but will invest in foreign funds when investing internationally. Second, foreign exchange gains and losses will occur when you invest overseas. Currency values change all the time. Hedging the foreign exchange exposure back to Australian dollars (local currency) will reduce the foreign exchange risk, but it cannot be completely eliminated. 2
Let s work an example of foreign exchange gains and losses. Let s assume one Australian dollar (AUD) is worth 80 cents US dollars (USD). If you purchase a US asset for USD 800 you need to pay AUD 1000. If the Australian dollar appreciates in value so that one AUD is worth one USD, your USD 800 investment is now only worth AUD 800. You have made a foreign exchange loss of AUD 200. Conversely, if the AUD fell in value to one AUD equaling 60 cents USD, then your USD 800 investment is now worth AUD 1333 (USD 800 / 0.60 = AUD 1333). You have made a foreign exchange gain of AUD 333. The chart below shows this example: Australian Dollar US Dollar Initial Exchange Rate AUD/USD = 0.80 $1000 $800 AUD appreciates AUD/USD = 1.00 $800 $800 AUD depreciates AUD/USD = 0.60 $1333 $800 What is Hedging? Hedging means selling the currency of the asset you purchased and purchasing your local currency. The most common way to do this is by a forward exchange contract with a bank. A forward exchange contract is where you agree to deliver a certain amount of the foreign currency to the bank at a future date at an agreed foreign exchange rate. Because you have agreed with the bank the exchange rate to be used in the future, you have reduced your risk of loss from your local currency appreciating in value against the currency in which your investment is denominated. 3
Show me how it works... Assume you purchased foreign shares valued at USD 800. The exchange rate was AUD/USD = 0.80 so, you paid AUD 1000 for the shares. This is USD 800 / 0.80 = AUD 1000 You hedge this currency exposure by entering a forward contract with a bank where you agree provide the bank USD 800 in 12 months time. You agree a forward exchange rate of AUD/ USD 0.778. You will receive in 12 months time AUD 1028 (USD 800 / 0.778 = AUD 1028) Now assume the AUD appreciates in 12 months to AUD/USD = 1.0. You shares are now worth AUD 800. You paid AUD 1000 but you only get back AUD 800. If you are unhedged, you made a loss of 200. But, you hedged your foreign exchange risk by entering the forward exchange contract with the bank. Your forward contract locked in your exchange rate at AUD/USD = 0.778. This means that you get AUD 1028 from the transaction. This gives you a gain of AUD 228 (AUD 1028 AUD 800 = AUD 228). This gain slightly more than offsets the loss on your shares (see forward exchange premium below for the reason for the small gain). You are hedged. How Much Should You Hedge? There is no conventional wisdom on whether you should hedge your foreign investments back into your local currency or not. Academics and investment professionals all have different opinions and often settle on hedging half their foreign assets because then you are half right and half wrong. Hardly the thought process of high-powered intellectuals! There are good reasons to hedge and good reasons not to hedge. One thing to remember is that if you cannot afford to take the foreign exchange loss if your local currency appreciates in value, then some foreign currency hedging is appropriate. 4
Reasons for not hedging your foreign investments back into local currency include: Currency diversifies your risk. If the Australian economy starts to falter then the Australian dollar will depreciate in value and your unhedged foreign investments will increase in Australian dollar terms. Examples of this were the Asian crisis, the 2008 GFC and the recent decline in commodity prices in 2014/15. Costs of a hedging program. Individuals find hedging very difficult as they need to arrange forward exchange cover with a bank (that takes large margins) and they need to manage the cash flows resulting from maturing forward exchange contracts (often every 3-6 months). This leads to many individuals believing if the currency exposure is not a significant portion of the investment portfolio then it is easier not have a hedging program and to live with the currency volatility. It all washes out in the long run. This is a highly debated area the view is that the Australian dollar goes up and down, so why hedge if at some stage the currency will be back where it once was? The counter argument is that there is no basis for this view. If you needed to repay Swiss Francs at the moment, you might think it could take a very long time before the Australian dollar caught back up. Consumption basket. Retirees will consume goods and services that are not denominated in Australian dollars. These include obvious things like overseas holidays but also foreign items such as computers, oil and pharmaceuticals. If the Australian dollar depreciates and these items become more expensive in Australian terms, having an unhedged portion of your retirement savings should produce a gain to compensate somewhat for these higher prices. 5
The reasons to be fully hedged back to the Australian dollar include: Currency is an unrewarded risk and should be eliminated. Investors cannot blindly invest in a foreign currency and expect to make a profit. In theory, you can passively invest in cash, bonds, property and shares and expect to make a positive return. But you cannot do this with currencies. If one currency is appreciating then by definition another currency is depreciating. Investors should not take risks without getting an expected return. This is not the case with currency, so the risk should be removed. Forward exchange premium. This is a little understood but vital piece of financial information. It is to do with how forward exchange prices are calculated by banks. Forward exchange currency rates are not set by financial dealers thinking what the Australian dollar will trade in say 3, 6 or 12 months time. Forward exchange rates are actually based on the current exchange rate for the currency adjusted for the interest rates of the two currencies being traded. Let s look at an example. Assume the Australian dollar is worth USD 80 cents Assume the 12-month interest rate in Australia is 3% and the 12-month rate in the US is 0.25%. The AUD forward exchange rate will be lower by the interest rate differential, being 3.00% - 0.25% = 2.75%. The forward exchange rate in 12 month time set today will be AUD/ USD = 0.80 (0.80 * 2.75%) = 0.778. If you sold your USD for AUD forward in 12 months time you actually have a more favorable exchange rate than the current spot rate. For example USD 800 / 0.80 = AUD 1000 but USD 800 / 0.778 = 1028. An additional gain of AUD 28. If Australian dollar interest rates are higher than foreign currency interest rates there is a financial benefit from hedging forward. The opposite occurs if Australian interest rates are lower than foreign interest rates. 6
What Should You Do? There is no right answer on how much currency risk you should hedge back into Australian dollars. Some expert advice should be sought, but beware as this is a topic with few experts. From Big Future, here are some suggestions for contemplation. If the amount of foreign currency exposure in your portfolio is small (less than 15%) then the costs of trying to manage forward exchange contracts is too high, and you may consider remaining unhedged. You do not have the costs of running currency-hedging program and you do get some diversification benefits from having some currency exposure. However, you will have to deal with currency volatility and the risk of losing money if the Australian dollar appreciates in value. If you can not afford to take a foreign exchange loss which frequently can be more than 20%, then some hedging is appropriate. If you are investing more than 15% of your assets in foreign currency then some hedging program may make sense. But this can be hard. Investing in a foreign currency fund may make sense but you will need to read the Product Disclosure Statement to understand what hedging the fund undertakes. Unless you are really competent in currency management, it is difficult to recommend that you try to manage your own international investments. Want More? BigFuture.com.au 7