Getting a grip on foreign exchange

Sep 19, 2017

Currencies can boost returns — but they can also decimate portfolios if their risk is not carefully managed. We discuss why, where and how to hedge currency risk – and outline our approach in taking active foreign exchange (FX) risk.

Currencies are complicated, and we believe that taking FX risk is not rewarded over the medium to long-term investment horizons of most investors. We generally see FX as a portfolio risk that needs careful assessment and management, rather than as an opportunity to generate additional returns.

Why hedge? With no clear return benefit over time, the key aim for many long-term investors is to reduce volatility. Currency moves can greatly increase the volatility of portfolio holdings. This is particularly the case for low-yielding fixed income assets, as the green bars in the Keeping a lid on volatility chart below show.

Keeping a lid on volatility
Expected index volatility with and without FX hedging

Chart: Expected index volatility with and without foreign exchange hedging

Sources: BlackRock Investment Institute and BlackRock Client Solutions, with data from Aladdin, August 2017.
Notes: The chart shows expected volatility based on current index weights and a constant-weighted 201 months of history. Volatility is broken down by contribution of the risk factors of the BlackRock Aladdin risk model. The hedged bars (the second bar for each asset class) show the impact that hedging all FX risk would have on risk levels from a U.S. dollar perspective. Global bonds are represented by Bloomberg Barclays Global Aggregate Index; EM bonds by JP Morgan GBI-EM Index; Japan by Tokyo Stock Price Index (TOPIX); the eurozone by Euro Stoxx 50; and the UK by FTSE 100.

Key highlights

  • The impact is less for equities relative to overall risk —yet still large. Currency risk adds significantly to overall portfolio volatility in eurozone and UK equities. The exception is Japan, because of the yen’s propensity to move in the opposite direction of the domestic stock market.
  • We suggest investors hedge most of their FX exposures in major developed markets (DM). We favor fully hedging fixed income allocations and leaving a portion of equity holdings unhedged, especially for European investors. We give our preferred hedge ratios for standard portfolios, and explain why we favor permanent hedges over dynamically trying to maintain a set level of FX exposures.
  • We see some room for taking FX risk in the short term, keeping in mind the liquid, 24-hour market is often the first to respond to unexpected events. We outline what we see as key drivers of currency moves: policies affecting interest rate differentials, investor sentiment and other technical factors, valuations and economic fundamentals. We conclude we currently have low conviction on most currencies.

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Isabelle Mateos y Lago
Global Macro Strategist, BlackRock Investment Institute
Isabelle Mateos y Lago, Managing Director, is BlackRock's Chief Multi-Asset Strategist. As part of the BlackRock Investment Institute (BII), she is responsible ...
Thomas Becker
Global Tactical Asset Allocation
Thomas Becker, PhD, Director, is a member of GTAA within BlackRock's Multi-Asset Strategies group. He is a portfolio manager and fixed income ...
Member of BlackRock Asia Pacific Fixed Income team
Member of BlackRock Client Solutions team
Pablo Goldberg
Portfolio Manager, Emerging Market Debt
Pablo Goldberg, Managing Director, is Head of Research and Portfolio Manager for BlackRock's Emerging Market Debt Team. Mr. Goldberg's responsibilities include ...
Multi-Asset Strategist, BlackRock Investment Institute