In an environment where the value of the US dollar has been going down and there is the potential for it to be further devalued, I realized I had no idea how the currency hedges done by hedged international stock and bond funds would work for US investors.
Over the last few decades where the assumption was generally “dollar strong, don’t want foreign currencies dropping to eat the returns of dollars invested internationally” those hedges were essentially a form of downside insurance for exchange rates wiping out returns “from the dollar perspective.”
I admit to a lot of ignorance about how the funds actually implement hedging strategies, but are they bi directional or are they just implemented to insure against downside currency risk from the dollar perspective? That is, if an international bond paying interest in Euros is hedged now and the dollar is falling, does the hedging effectively make performance worse from the dollar perspective? Or is it just a downside hedge and so even a hedged fund could benefit from the dollar weakening compared to the currency the fund was invested in?
Question on Currency Hedged ETFs or Mutual Funds
byu/Mirabolis ininvesting
Posted by Mirabolis
2 Comments
I work with a couple of clients like this. They have a fund with the underlying denominated in a different currency. They will call their bank and trade what is called an FX swap to roll over the forward leg and hedge the currency exposure. They will not realize the far leg of the swap, rather roll it over every couple of months, exposing them to the carry cost (IR differential risk) WHEN they roll over again. But they are not speculating, they are rolling over at the prevalent market rate. If you don’t want to express a currency view, then this completely protects you and is traded at the market rate (limits you from upside gains and protects you from downside risk.)
If you only want downside protection the fund would need to call the bank and buy EUR/USD put options but that would be expensive if implied vol is high and they would pay a high premium. Most likely pass on the cost through the expense ratio. Not many funds use this method, either hedge it with a swap or don’t hedge it at all.
>That is, if an international bond paying interest in Euros is hedged now and the dollar is falling, does the hedging effectively make performance worse from the dollar perspective?
Yes , in this case the unhedged version of the fund would rise in value in USD as the Euro moved higher vs the USD