ACTV - Adapting To The Shift In Hedging Costs
2023-03-11 06:36:00 ET
Summary
- The rapid increase in central bank policy rates globally has meant that the cost of hedging currency exposure on foreign assets for many investors has changed significantly.
- The rapid change in cost for some investors has significant implications for allocating capital to foreign currency-denominated assets.
- Investors may choose to respond to the increased importance of hedging costs in one of four ways.
By Paul Stewart
The cost of hedging foreign assets has changed significantly since pre-COVID; investors may choose to respond in four ways.
The rapid increase in central bank policy rates globally has meant that the cost of hedging currency exposure on foreign assets for many investors has changed significantly. For many years, policy rates across the major economies were low and the differential between countries minimal. This meant that investors could allocate capital to assets denominated in foreign currencies and mitigate the currency risk for little to no cost. For example, just before the outbreak of COVID-19, the price for both European and Japanese investors to hedge the currency risk on U.S. dollar-denominated assets was around 2.5% annualized.*
The increase in inflation rates since COVID-19 and the consequent monetary policy response has changed this significantly. At the time of writing, the same cost is more than 5% for Japanese investors and around 2% for European investors.
Looking ahead, as central banks reach their terminal rate, we expect hedging costs to settle in a range of +/- 0.50% around 1.50% for European investors, 5.25% for Japanese investors and 0.75% for U.K. investors all to hedge U.S. dollar denominated assets.*
The rapid change in cost for some investors has significant implications for allocating capital to foreign currency-denominated assets. Either the cost must be factored into the expected return of the asset, or else the currency risk must be taken into consideration when deciding on portfolio allocations.
Investors may choose to respond to the increased importance of hedging costs in one of four ways:
For some investors, notably those who for years faced negative domestic yields on fixed income securities, a now positive yield plus the increased cost of hedging currency exposure of foreign bonds may lead to an increased allocation to domestic fixed income.
Alternatively, the rise in hedging costs may incentivize investors to take additional duration, liquidity or credit risk when allocating to foreign assets to compensate for the increased cost of hedging currency exposure.
A third option for investors is to leave foreign assets unhedged, to avoid the cost of hedging but at the expense of added volatility stemming from exchange-rate movements.
A final option is to implement a more sophisticated hedging strategy such as that discussed in our 2016 white paper, “Managing Currency Risk: An Opportunistic Framework for Institutional Portfolios,” which opportunistically adjusts the hedge ratio based on the cost of hedging and currency valuation.
*Data from Bloomberg, as of March 10
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Adapting To The Shift In Hedging Costs