Back to basics on currency hedging

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Banknotes of the bric states on white background © / 123RF Stock PhotosThe world was caught off guard when the U.K. voted to leave the European Union on June 23, 2016, since the majority of polls had predicted the opposite outcome.

In the wake of the vote, the British pound fell in value relative to other currencies to levels not seen since 1985. It’s a real-time example of how quickly a currency’s value can change and how wrong reasonable indicators can be. These realities, depending on the type of investor, can provide arguments for and against currency hedging.

How hedging works

Hedging is taking a position to mitigate any potential losses or gains incurred by an investment. For example, if a Canadian pension fund bought an office building in Brazil, the rent paid by the tenants would be in Brazilian real. The rental income generated would fluctuate based on the value of the real, since that money would eventually be converted into Canadian dollars. So the moment the pension fund chooses to convert the rental income into its domestic currency would have a material effect on how profitable the investment is over time.

When considering whether or not to hedge an investment, a pension fund has two choices — it can either accept the inherent risk in the fluctuation of the transaction’s currencies, or it can attempt to neutralize that risk. With currency, hedging usually involves purchasing derivatives, such as futures contracts, forward contracts or options. Typically, futures contracts are meant to behave in the opposite manner to the asset they’re hedging. Alternatively, options allow a plan to convert currency at a set rate of exchange, effectively eliminating the currency issue altogether. Forward contracts are similar, but dictate that an investor must make an exchange at a set rate and a specific time. All of these choices also come at the cost of the time and expense it takes to implement them.

Should investors hedge?

As Brexit demonstrated, predicting the direction of global currencies is essentially impossible. However, Brexit and other global surprises haven’t dissuaded investors from attempting to make the most informed, forward-looking decisions they can — and currencies are a part of that process.

As the U.K. closes in on the practicalities of separating from the E.U., it will be extremely difficult to predict how the outcome will affect the British pound, says Nick Purser, director at Orbis Investment Advisory Ltd. There’s no guarantee of success when making a significant bet on the currency’s direction, but it would be reasonable to position investments, including hedges, with an expectation of increased volatility given the situation’s uncertain outcome, he says.

Economic indicators also factor into any analysis of a currency’s value. For example, a continuing trend of inflation in a country’s economy would likely contribute to a depreciation in the value of its currency, says Purser.

Either way, investors shouldn’t take hedging on lightly, he says. “Having a clear, long-term framework for currency management is likely to be beneficial. The decision about whether, or how, to hedge can have a pronounced impact on a portfolio. At times, when this impact is negative, it has the potential to put pressure on the framework itself. Consequently, it is important to have a level of commitment to the framework to ensure it is not abandoned without appropriate justification.”

This article originally appeared on CIR’s companion site, Read the full story here.

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