If you are in the process of constructing a well-diversified investment portfolio with the aim to generate long-term investment returns, it will be only natural to look beyond your country’s borders, with the intention to invest in foreign currency denominated securities. While investing in international stocks and bonds is a great way to diversify your portfolio you need to be away of the extra risk you are running, if those securities are not denominated in your country’s domestic currency. That risk is currency risk.
If you are based in the United States, but want to purchase securities in euros, sterling or Australian dollars you, will be exchanging your dollars into the foreign currencies, so that you are able to purchase the securities. While the foreign stocks and bonds you purchase may perform well and generate returns, if the currencies they are denominated in weaken against the U.S. dollar this will reduce your returns or could even lead to a loss, if the currency moves are strong.
Therefore, if you want to invest in international securities, denominated in another currency than your portfolio’s base currency, it only makes sense if you invest with higher volumes, as then you can use foreign exchange payment providers that let exchange your currencies at a fraction of the cost than your bank. Banks often charge 1-3% for currency transactions. Hence, using commercial currency exchange companies, instead, let’s you hedge your portfolio currency risk at a much cheaper rate. Thus, effectively adding to your overall portfolio returns.
An alternative to an active currency hedging approach for your investments would be to build a portfolio purely in your domestic currency. For example, if you are based in the United States, you could buy a portfolio of only USD-denominated securities. Many large foreign multinational companies issue securities that are denominated in U.S. dollars. That way you are able to invest, for example, in bonds of German car companies, such as Volkswagen or BMW, or European oil companies such as Shell and Total in U.S. dollars. Thereby, you can circumvent the currency risk of international securities exposure.
This is also one of the main reasons why so many issuers from emerging markets, such as China, Brazil and India, are issuing bonds in U.S. dollars. That way the issuing companies can attract international investors that do not have to be concerned with the volatility of emerging markets currencies. Emerging markets currencies have weakened substantially versus the U.S. dollar in the last few months. For example, the South African rand weakened 15% against the U.S. dollar in the last 6 months, while the Russian ruble dropped 8% and the Mexican peso 6% against the dollar during the same time period. If you had holdings in securities in any of those three currencies in the last 6 months and your returns on those were, for example 5%, then you would still have made a loss on those investments. Hence, hedging your currency risk when you invest in international securities is imperative to ensure stable returns for your investment portfolio.
Having said that, there is also a draw back if you hedge the currency risk of your foreign investments. That drawback is that you will not benefit from a strengthening of those currencies, if you hedge your currency exposure. If you believe that the currencies of your foreign investments will strengthen against your portfolio base currency during your investment period, then it would be wiser not to hedge your currency exposure. This, however, is a rather risky investment approach as adverse currency moves will have quite an effect on your returns, should you turn out to be wrong.