MERITS OF CURRENCY HEDGING

The foreign exchange market is a marketplace for best opportunities yet greatest trading risks, which are then integrated in nearly all investments, including mutual funds. Thus, it is imperative hedge currency risks. Here’s why.

Foreign stocks help in diversification. Minimize losses and maximize gains by investing in different types of asset classes. For instance, you can have stocks from American firms and from foreign companies at the same time. If you venture in foreign investments, currency-hedged mutual funds and ETFs can do the trick.

Alleviate huge currency slides. Economic data and news influence exchange rate movements in many ways. For example, if a central bank votes to hike interest rates, the currency’s value can increase or decrease. Rates tend to be very erratic. In order to avoid losing more value, currency hedging technique should be applied. The strategy is somewhat costly, but it can shield investments in the long stretch.

For example, two mutual funds hold stocks of UK-based entities. The difference is the first fund does not use currency hedging and the second one purchases forward contracts (more on this later) on the British pound although it owns the exact stocks. Now, if the currency’s value stays the same or climbs, the portfolio that is not hedged will outshine because it is not necessary to pay for forward contracts. If the currency’s value tumbles, the hedged portfolio performs better.

Offsetting cost of currency forward eventually. Also called forward contracts, it is a contract locking in the exchange rate for trading a currency at a preset date and time. The binding contract essentially protects a portfolio’s value in case the prevailing rates make the currency less profitable. This is a great tool for hedging currency risks. But it is costly. Funds are basically designed to lower risk and take on the additional expense of purchasing such a contract.

Reducing perils. Several factors impact the exchange rate between two currencies. Let’s say an ETF is denominated in US dollars. Make the most of the instrument by hedging the currency risk.