Investment strategy: Currency strategy and currency hedging

Investing in foreign securities (also) entails a currency risk. As all foreign currency exposures represent a zero-sum game when consolidated – one side gains and the other loses to the same extent – currency risk is not compensated with a premium. It follows that currency risk should generally be hedged.

From the perspective of a low-interest currency such as the CHF, the difficulty is that every hedging transaction eliminates the interest rate differential against the foreign currency. A simplified example: one dollar costs one franc today. If I conclude a forward agreement today to buy back this dollar in one year, I will only receive 96 centimes in a year due to the current interest rate differential of around 4%. The hedging decision therefore becomes a trade-off: am I willing to hedge the currency risk in exchange for losing the interest rate differential?

This trade-off depends on how I assess the development of the USD/CHF exchange rate over the hedging period. The most widely used theory for exchange rate forecasts is uncovered interest parity (UIP). This assumes that the exchange rate will adjust exactly by the interest rate differential, meaning that in the example the USD/CHF exchange rate would be exactly 96 centimes in one year. If this happens, it makes no difference whether the position was hedged or not – although hedging allows one to sleep more peacefully and reduces risk.

As illustrated in the chart of the week, uncovered interest parity has worked surprisingly well for the CHF over the past ten years. The CHF has appreciated against the major foreign currencies roughly in line with the interest rate differential. As a result, it made little difference whether foreign equity or bond portfolios were hedged or not. However, deriving a general rule from this observation would be presumptuous: for the other global low-interest currency, the Japanese yen, uncovered interest parity has not worked at all and Japanese investors historically performed better without hedging their currency risk.

As always when facing a trade-off, a pragmatic middle ground helps: a reasonable practice is to hedge foreign currency bonds (or possibly exclude them altogether – more on this in the next Flash) while leaving the currency exposure for foreign equities unhedged. This is also how we construct the Economico standard portfolios.