28.05.19
Insights

Portfolio currency hedging 101 – Impacts and costs – What you need to understand

There is a lot of confusion and uncertainty when I discuss portfolio currency hedging with investors. I often meet the expression «hedging cost» and it often refers to the interest rate differentials (long the interbank rate you hedge to and short the interbank rate you hedge from). This is not the real hedge cost, but the hedge impact. The hedge cost is OTC trading costs, credit risk and bid/offer imbalance. Confused already?

Why is currency prices and hedging so hard to understand in general? The price is a relative price of two assets, this is much harder to grasp than the pricing of one single asset. Adding a derivative aspect to this as we do for hedging, does not make it easier.

Let’s go through this and hopefully we’ll all have a clearer understanding of this at the end of the article. I’m simplifying in the following to better show the principles.

Portfolio currency hedging – What do we seek?

When we hedge, we seek to change the exposure of our assets from one currency to another by locking in the future exchange rate. For instance, as a euro (EUR) based investor I may have a bond portfolio with bonds issued in Norwegian kroner (NOK) and I wish to change the currency exposure to EUR.  This will make the value and returns of my investment sensitive to the changes in bond prices of the NOK bonds, but not to a change in the EURNOK exchange rate. If I do not hedge, the value and returns of my investment will be sensitive to the changes in bond prices of the NOK bonds and to a change in the EURNOK exchange rate.

Portfolio currency hedging – How do we hedge?

A simple hedge of the above bond portfolio would be to sell EURNOK forwards for the value of the portfolio. It is usual to do this on a one or three month horison. The first implies 12 rolls (or renewals) per year and the latter 4 rolls. Some investors hedge more precisely by hedging each holding individually in the portfolio.

Portfolio currency hedging – What are the impacts?

The hedge will have different impacts on the value and returns of my investment, these need to be added together to get the total impact.

1. The sensitivity to the asset’s local currency is taken away, so the performance and the valuation will be the same as for a locally based investor, in this example as an investor in Norway.

2. As the EURNOK forward I have sold is in reality taking a short position in the NOK interbank rates (+1.4% end April 2019) and a long position in the EUR interbank rates (-0.3% end April 2019), this will impact the returns of my investment by this differential. At end April 2019 levels, this would reduce the yearly returns by 1.7%. These interbank rates do change, so does the interest rate spread or differential. GRAPH 1 shows the historic evolution of this specific interest rate differential.

GRAPH 1 – Historic interbank rate differential (%) – Hedging NOK to EUR (long EUR and short NOK)

Insight 2019 05 - Portfolio currency hedging 101 - Graph 1

Source: Bloomberg, end April 2019. Historic performance is not an indicator of future performance.

As can be seen in GRAPH 2, the NAV hedged to EUR has a similar steady performance as the NAV in NOK, but with lower performance. The difference is explained by the interest differential as shown in GRAPH 1.  The NAV measured in EUR (not hedged) is much more volatile as can be seen below.


GRAPH 2 – Examples of hedged and non-hedged short bond fund classes based on the interest rate differential

Insight 2019 05 - Portfolio currency hedging 101 - Graph 2

Source: Bloomberg, end April 2019. All series based to 100 end June 2009. Historic performance is not an indicator of future performance.

3. If you wish to be more precise, the price of the Forwards is in reality set by the above mentioned interest rate differential plus the OTC trading costs, the credit risk and the bid/offer imbalance. With other words if there is a high demand to hedge from NOK to EUR, the number in point 2 will actually be higher than the 1.7%. And vice versa.
In the following graph you can see the real cost of hedging, this is the part of the forward pricing that is not explained by the current interest rate differential. This hedge cost is often referred to as the basis. Since 2009 for the EURNOK, the basis has varied roughly between +0.25% and -0.15%.

GRAPH 3 – The real hedge cost – the pricing of the forwards not explained by the interest rate differential

Insight 2019 05 - Portfolio currency hedging 101 - Graph 3

Source: Bloomberg, end April 2019. Historic performance is not an indicator of future performance.


It is interesting to notice how the hedge cost from NOK to EUR increased when hedging when the oil price fell a lot in 2014-2016 and the opposite when the Brent oil price in NOK moved upwards again in 2016-2019. This could be explained by bigger interest to hedge from NOK to EUR in the period where the oil price was weakening and vce versa.

Hereunder, I have added the NAV hedged to EUR using the real forward prices. Due to the basis, the performance impact is a little more negative compared to the NAV hedged to EUR calculation with only the interest rate differential. In the big picture is has still been a marginal effect for the studied period.

GRAPH 4 – Adding the NAV hedged to EUR using the real forward prices

Insight 2019 05 - Portfolio currency hedging 101 - Graph 4

Source: Bloomberg, end April 2019. Historic performance is not an indicator of future performance.

Portfolio currency hedging – When is it used in reality?
  • Currency hedging can be directional, you wish to speculate and you hedge because you expect currency prices to change, with other words you increase returns due to the hedge if you’re right. And vice versa.
  • Some clients do simply not wish currency exposure and some cannot take on currency exposure.
  • Hedging is more often used with bond portfolios than with equity portfolios, the reason for this is that expected volatility and returns are much higher for equities and therefore the currency impact is expected to be minor to the total volatility and return. For bond portfolios the expected volatility and returns are lower and the currency impact can be bigger than the portfolio volatility and return itself.
Conclusion – portfolio currency hedging

Many struggle with understanding currency exchange rates mechanisms as they price pairs and not one asset. Adding the derivative aspects does not make it easier. Hedging costs are really only the OTC trading costs, credit risk and bid/offer imbalance effects, despite most using the expression meaning it includes the interest rate differential. Hopefully the above has been of help in getting a clearer picture of some of the portfolio currency hedging’s what and how.

 

Dag A.D. Messelt
Head of  International Business Development

On the same subject:

The Norwegian krone’s correlation to the Brent oil price

«When the oil price tanks eyes turns to the NOKie». We often see the Brent oil price as a factor for explanation of the moves in the Norwegian krone (NOK) versus other currencies, but how does it really work over time? We have been looking closer to this relationship and have some interesting findings. These findings can be split in three levels:

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Investments in funds are always related to risk. Past performance is no guarantee of future results. Performances are calculated net of fees. Investments in funds are subject to market fluctuation and risks inherent in investing in securities. The value of investments and the revenue they generate can increase or decrease and it is possible that investors will not recover their initial investment.