Buying an asset denominated in another currency creates two exposures at once: the asset, and the currency. They can move independently, and the currency move is often the larger of the two over short periods.
Two kinds of risk
Transaction risk arises when cash flows cross currencies. A dividend paid in euros must be converted, and the amount received depends on the rate that day.
Translation risk is the change in the reported value of a foreign holding caused by a rate move, even with no transaction. A holding that is unchanged in its own currency falls in value in the reporting currency if that currency strengthens.
An investor spending in one currency while holding assets in another carries both.
What actually drives the rate
Three influences matter most over the horizons that concern a portfolio:
- Interest rate differentials. Capital tends to move toward higher yields, all else equal. This is the dominant short-to-medium term driver.
- Inflation differentials. Over long periods, a currency tends to depreciate roughly in line with the inflation gap between two economies. This is the dominant long-term driver.
- Risk sentiment. In stress, capital flows toward currencies perceived as safe havens, often strengthening them independently of the other two factors.
None of these is reliably forecastable. Treating a currency view as a tradeable certainty is a common and expensive mistake.
The offset you already have
An important and often overlooked point: currency exposure is not purely additive. A company that earns revenue abroad has foreign exposure whether or not the investor buys it directly. Buying the shares of an exporter in the domestic market is a currency position taken through the equity.
For a globally diversified equity portfolio, some currency diversification is inherent in the holdings themselves, and adding an explicit currency position may be doubling up rather than diversifying.
To hedge or not
Hedging removes the currency effect; it does not remove the asset risk. It converts a two-factor exposure into a one-factor exposure, at a cost.
Considerations:
- Cost. A hedge is a contract with a price, usually reflecting the interest rate differential. Hedging a high-yield currency is expensive, which is not a coincidence — the higher yield is compensation for something.
- Objective. A portfolio whose purpose is to fund liabilities in one currency has a reason to hedge. A portfolio deliberately seeking global diversification may not.
- Horizon. Currency effects largely wash out over long periods and dominate over short ones. A long-horizon investor has less reason to pay to remove a short-term effect.
- Whether it is deliberate. The worst outcome is an unhedged position taken by accident, and discovered after the move.
The practical summary
- Know what the exposure is. Currency is part of the position, whether it was intended or not.
- Size it like anything else. Currency volatility is comparable to equity volatility, and it should be counted in the risk budget, not dismissed as a rounding error.
- Decide deliberately. A considered decision not to hedge is a position. So is a hedge. An unexamined default is neither.