Currency Hedging is a risk management strategy used by investors, businesses, and financial institutions to protect against fluctuations in exchange rates.
Technically, it involves using financial instruments, such as forward contracts or options, to lock in exchange rates, reducing the risk of currency volatility.
There are ETFs that offer built-in currency hedging, designed to protect investors from exchange rate fluctuations when investing in foreign assets.
While they can be efficient for reducing currency risk, they typically come with a higher Total Expense Ratio (TER) compared to unhedged ETFs due to the additional costs of managing the hedging strategy.
Currency Hedging Costs as of October 2024
The simulation of hedging costs here is done by considering the interest rate differential between two currencies. This method provides a straightforward yet effective approximation of the actual hedging cost.
Hedging a currency with a higher reference interest rate than the one being hedged results in a cost.
Conversely, if the reference interest rate is lower, the hedging cost is negative, effectively providing an extra return for the investor.
| Hedged Currency | Reference Interest Rate |
Hedging against - Current Annualized Hedging Cost (%) |
|||||
|---|---|---|---|---|---|---|---|
| USD | CAD | EUR | GBP | JPY | AUD | ||
| USD | 5.00% | - | -0.71% | -1.29% | 0.00% | -4.52% | -0.62% |
| CAD | 4.25% | 0.72% | - | -0.58% | 0.72% | -3.84% | 0.10% |
| EUR | 3.65% | 1.30% | 0.58% | - | 1.30% | -3.28% | 0.68% |
| GBP | 5.00% | 0.00% | -0.71% | -1.29% | - | -4.52% | -0.62% |
| JPY | 0.25% | 4.74% | 3.99% | 3.39% | 4.74% | - | 4.09% |
| AUD | 4.35% | 0.62% | -0.10% | -0.67% | 0.62% | -3.93% | - |
While hedging costs may seem like an extra expense, they provide valuable protection against currency fluctuations. Exchange rate movements can often be much larger and more unpredictable than the cost of hedging. By managing this risk, investors can achieve more stable returns and avoid potential losses due to volatile exchange rates.
