Currency Hedging: The Cost of Managing Risk

“Between calculated risk and reckless decision-making lies the dividing line between profit and loss” ― Charles Duhigg

4 min read

Currency Hedging: The Cost of Managing Risk

“Between calculated risk and reckless decision-making lies the dividing line between profit and loss” ― Charles Duhigg

4 min read

Businesses and investors are increasingly exposed to risks stemming from fluctuations in foreign exchange rates. Currency movements can impact the value of investments, affect profitability, and introduce uncertainty into international transactions.

However, there is a way to mitigate your exposure to currency risk, and this is through a strategy known as ‘hedging’.

For you, the investor, hedging is simple as it involves simply buying a fund that has ‘hedged’ in the name or fund literature.

Under the bonnet, currency hedging involves a range of financial instruments designed to mitigate the potential adverse effects of currency fluctuations on your investment portfolios, business revenues, and cashflows.

This article aims to help you make informed decisions about whether currency hedging is the right strategy for your investments, or not. So, read below to find out more!

What is Currency Hedging?

Currency hedging is a risk management strategy used to mitigate the impact of currency fluctuations on international investments or transactions.

It involves taking positions in the foreign exchange (FOREX) market to offset potential losses that can come from changes in exchange rates.

Currency hedging aims to protect against adverse movements in currency values that could erode the value of investments denominated in foreign currencies.

One common method of currency hedging is through the use of financial derivatives such as forward contracts, futures contracts, options, and swaps.

Essentially, by hedging a certain currency, you are taking a position on the future direction of that currency’s movements. This is akin to placing a bet on whether a particular currency will appreciate or depreciate. So, you are locking in a specific exchange rate to protect yourself from adverse currency movements.

These instruments allow you to lock in exchange rates at predetermined levels, providing certainty about future cash flows and reducing the uncertainty associated with currency risk. However, whilst currency hedging can help smooth out your returns and protect against losses in currency fluctuations, it also comes with costs and complexities that you need to consider carefully.

Is Currency Hedging Good or Bad?

The effectiveness of currency hedging depends on various factors, including your specific circumstances, market conditions, and investment objectives.

As mentioned, you are placing a bet on whether a particular currency will appreciate or depreciate, locking in a specific exchange rate, and you do not get to do this for free!

Just like any insurance policy, currency hedging requires paying a premium, typically in the form of management fees or transaction costs. These costs can then eat into your potential profits and diminish your returns (which is especially true if the currency movements do not move in your favour).

In some cases, currency hedging can provide valuable protection against currency risk, particularly for those with significant exposure to foreign markets or those holding international assets. You can even potentially enhance risk-adjusted returns over the long term whilst enjoying reduced volatility in your portfolio.

However, do not be fooled, hedging does not eliminate currency risk entirely and may not always be effective in volatile or unpredictable market conditions.

What’s more is that hedging decisions should not just be a quick thought of “I am investing in a foreign currency so I should buy a fund that implements hedging”. In reality, this decision requires careful consideration and expertise, and improper hedging strategies can result in unintended consequences or losses.

Therefore, you should weigh the pros and cons of currency hedging carefully before implementing any strategies. Fortunately, Patterson Mills is here to help, so contact us today!

Considerations You Need To Make

When evaluating whether currency hedging is suitable, there are several consideratinos for you to make.

Determine your risk tolerance and investment objectives
Find out the level of exposure to foreign currencies in your existing or planned portfolio
Consider the outlook for currency markets, economic fundamentals, and geopolitical developments that could impact exchange rates.
Evaluate the costs associated with currency hedging and compare them to the potential benefits.
1. This includes considering the impact of hedging costs on investment returns and whether the expected reduction in currency risk justifies the expenses incurred.
Assess the performance of different hedging strategies under various market scenarios and their historical effectiveness in managing currency risk.
1. Remember, past performance is not indicative of future performance
Consider the prevailing interest rate differentials between currencies
Consult with Patterson Mills

Could Topiary Help Your Investments?

Our Advisers at Patterson Mills understand the importance of currency risk management and offer tailored solutions to help you navigate the challenges of international markets and decide if hedging would be suitable for you.

Whether you’re looking to hedge currency exposure in your investment portfolio or protect your business from currency fluctuations, our team can provide the guidance and support you need.

Get in touch with us today and book your initial, no-cost and no-obligation meeting.

Send us an e-mail to contactus@pattersonmills.ch or call us direct at +41 21 801 36 84 and we shall be pleased to assist you.

Please note that all content within this article has been prepared for information purposes only. This article does not constitute financial, legal or tax advice. Always ensure you speak to a regulated Financial Adviser before making any financial decisions.

Holding Foreign Currencies To Get a Higher Interest Rate: Should You Do It?

“Volatility gets you in the gut. There’s no question that when prices are jumping around, you feel different from when they’re stable” ― Peter Bernstein

4 min read

Holding Foreign Currencies To Get a Higher Interest Rate: Should You Do It?

“Volatility gets you in the gut. There’s no question that when prices are jumping around, you feel different from when they’re stable” ― Peter Bernstein

4 min read

We all want to get the most out of our money, especially when it comes to earning interest on our cash.

Sometimes, it may seem like the grass is greener on the other side, with foreign currency accounts offering higher interest rates than what is available in your home currency.

But is it really as good as it sounds?

It may seem obvious to gravitate towards the higher interest rates and receive more money each year. However, there may be more risks involved than you think.

Today, we are going to explore the ins and outs of foreign currency interest rates, and weigh the benefits and risks to help you make informed decisions about whether a foreign currency interest rate is right for you, or not.

Is Holding Cash in Foreign Currencies a Good Idea?

Opening an account in a foreign currency to capitalise on higher interest rates may seem appealing at first glance, especially if the rates offered are significantly higher than those available domestically.

However, whilst higher interest rates may enhance the potential returns on your cash, at least in terms of the actual figures you will see on your statement, they also come with increased currency risk.

Exchange rate fluctuations can significantly impact the overall return you receive, and could actually cause you to experience a reduction in purchasing power (i.e. lose money!).

Put simply, when placing funds in a currency other than the one in which you intend to spend the funds, you are making a bet that the foreign currency you choose will not lose value against your domestic currency by the difference of the increased interest rate you will receive.

Currency exchange costs, foreign transaction fees, and regulatory differences can all affect the net return, too. Moreover, navigating the regulatory landscape and tax implications of foreign investments may require specialised knowledge or professional advice, adding to the overall complexity and potential costs associated with utilising foreign currency accounts.

So, is it a good idea to utilise foreign currency accounts to get a better interest rate? Ultimately, it depends.

It depends on whether you are willing to accept increased risk, what your investment objectives are, and the broader economic environment at the time.

Whatever your decision, you should definitely be aware of a theory known as ‘Interest Rate Parity’.

What is Interest Rate Parity?

Interest rate parity is a concept in finance that relates to the relationship between interest rates and exchange rates in different countries.

Essentially, it states that the difference in interest rates between two countries should equal the expected change in exchange rates between their currencies.

In other words, if one country offers higher interest rates than another, its currency should depreciate relative to the currency of the country with lower interest rates to maintain equilibrium.

What this is saying is that your purchasing power won’t benefit from a higher interest rate in a foreign currency.

This principle is based on the idea of arbitrage, where people seek to exploit differences in interest rates and exchange rates to make risk-free profits.

If interest rate parity did not hold, it would be possible to borrow in a currency with low-interest rates, convert it to a currency with higher interest rates, invest at the higher rate, and then convert the returns back to the original currency, profiting from the interest rate differential.

Interest rate parity helps prevent such opportunities for risk-free profit, ensuring that currency markets remain efficient and prices reflect all available information.

Whilst interest rate parity provides a useful framework for understanding the relationship between interest rates and exchange rates, it is not in itself a perfect predictor of currency movements.

Various factors, such as economic conditions, inflation expectations, geopolitical events, and central bank policies, can influence exchange rates independently of interest rate differentials.

However, interest rate parity remains an important concept to know as, frankly, it’s saying there is no such thing as a free lunch!

Are Exchange Rates Really That Important?

In short, yes!

The volatility of currency exchange is not to be ignored. This refers to the degree of fluctuations or variability in the exchange rates between different currencies.

Currency exchange rates are typically highly volatile, fluxuating all the time.

Why? Well, the fluxuations are influenced by a myriad of factors, such as those mentioned for interest rates above, and present risks that you may not have considered.

Currency volatility adds an additional layer of uncertainty, so you may have thought you can get 2.00% interest for 1-year in your home country, and 5.00% for 1-year using foreign currencies and that’s great, right?

Well, if your domestic currency increases in value by 10% against that foreign currency, you actually have made a loss of 7.00% if you then convert it back into your home currency to spend.

The problem is, no matter what the past performance of a currency has been, the future is not known and the unexpected can happen!

Knowledge is Power, But What's The Answer?

There are two sides to every coin.

In this case, on the one side you make a loss from adverse currency fluctuations, and on the other side you make a profit from advantageous currency fluctuations.

If it goes your way, that would be great. The truth is, there is just no way of knowing.

This is why it is mentioned above that whether or not it is right for you really depends on your risk appetite, capacity for loss and personal circumstances.

Importantly, holding cash is investing, and this is even more true for those holding cash in a currency other than that in which those funds will be spent.

The key to success is that you need not make these important decisions alone.

Patterson Mills is here to guide you every step of the way and assist you in making the decision that is right for you and your financial future.

Get in touch with us today and book your initial, no-cost and no-obligation meeting.

Send us an e-mail to contactus@pattersonmills.ch or call us direct at +41 21 801 36 84 and we shall be pleased to assist you.