Hedging Currency Risk
Investing in international markets has benefits and costs. A key risk that needs to be carefully managed is the prospect of adverse exchange rate movements. This risk can be hedged using currency contracts.
Investing in international assets offers valuable portfolio diversification in the event that local shares and/or bonds perform poorly. However changes in exchange rates can adversely impact the portfolio. For example, an investor in British shares could see their total value increase in the UK currency but still make a loss if the Pound fell substantially in value, reducing the New Zealand dollar value of their investment.
One way to manage currency risk is to enter into currency contracts. Currency contracts lock in the exchange rate at which international assets are converted back to New Zealand dollars in the future. The investor is then protected from exchange rate changes.
This is illustrated below:
Without hedging, the 20% fall in Sterling sees the investment reduce in value from NZ $2.5 million, to NZ$2.0 million, a 20% loss.
With hedging, the investor can lock in the starting exchange rate of £1 = NZ$2.50 at year-end. Even if the investment is not sold, the investor can be paid out the $500,000 value of the hedging contract, which offsets the loss in the New Zealand dollar value of the shares.
To hedge effectively, investors need to regularly adjust the market value of their currency contracts to keep it consistent with the value of their international investments. Investors can fully hedge, partly hedge, or not hedge their exposure to foreign currencies, depending on their investment objectives and risk tolerance.
Want to know more?
Trust Management can provide advice to charities about managing the risk of their international investments, and achieving their investment objectives.
If you have any questions, or would like to know more about managing your currency risks, please do not hesitate to contact John Williams on (09) 550 4046.
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