To hedge or not to hedge

The New Zealand dollar is one of the most volatile currencies in the world. Movements in its value relative to other currencies can have a significant impact (in either a positive or negative way) on the cost of everyday items like petrol, food and a new pair of shoes. Currency fluctuations can also add to, or detract from, returns on global investments. Hedging can help investors reduce the ups and downs in their portfolios and achieve a more stable outcome.

Currency movements are caused by a variety of factors

A currency can be thought of as the share price of a country. A strong currency is indicative of an economy that is performing well, whereas a weak currency may reflect economic stress.

Fluctuations in exchange rates are caused by a variety of factors. Interest rate differences between countries, inflation changes, trade balances and political risks are just some examples.

A country with a large trade deficit typically experiences a depreciation of its currency. This is because its currency gets sold in exchange for foreign currency to pay for imports. Conversely, a nation with a large trade surplus experiences a currency appreciation.

Currency movements can be favourable or unfavourable

A strong New Zealand dollar is favourable when it comes to travelling or buying goods imported from overseas. This also applies when purchasing shares in international companies, such as Microsoft.

However, if the New Zealand dollar appreciates further after your Microsoft shares have been purchased, the value of those shares will fall when measured in our local currency. This is illustrated in the following example.

Example

Let’s assume the NZD/USD exchange rate is US$0.60 at the time of your investment in Microsoft. This means NZ$1.00 would buy you US$0.60.

If you had NZ$10,000 to invest, you could purchase US$6,000 worth of Microsoft shares.

At a price of US$300 per share, this would equate to 20 shares. Fast forward a year and assume that Microsoft’s share price is unchanged, but the New Zealand dollar has appreciated in value to US$0.70.

While the value of your Microsoft shares haven’t changed in US dollars (US$300 x 20 shares = US$6,000), their value has reduced from NZ$10,000 to NZ$8,571 when measured in our local currency (US$6,000 ÷ US$0.70 = NZ$8,571). If the New Zealand dollar had instead depreciated to say US$0.50, your Microsoft shares would have gained in value to NZ$12,000 (US$6,000 ÷ US$0.50 = NZ$12,000).

In this example, the performance of your underlying investment in Microsoft is overshadowed by currency movements, which are very difficult to predict.

This is where currency hedging has a role to play.

The rationale for currency hedging

Currency hedging can be a valuable tool for investors who participate in global financial markets. By partially or fully hedging currency risk, investors are able to reduce the ups and downs in their portfolios and achieve a more stable outcome.

Returns more closely reflect how the underlying assets perform, rather than the impacts of currency fluctuations. Currency hedging is particularly relevant when investing in global fixed income, given a key role of bonds is to provide a predictable and reliable income stream.

Volatility in currency markets can significantly affect the returns of an international bond portfolio, if left unhedged.

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