Currency hedging

An investment can rise in its own market and still lose money for you. If you measure wealth in dollars and buy a euro bond that gains in price while the euro falls against the dollar, the currency move can erase the gain. Currency hedging is how investors separate the return they wanted from the exchange-rate move they did not ask for.

How a currency hedge works

The usual tool is a forward contract: an agreement today to exchange one currency for another at a set rate on a future date. A dollar-based investor who owns euro assets sells euros forward in the same amount. If the euro then falls, the assets lose value in dollar terms, but the forward contract gains about the same amount, because it locks in the earlier rate. If the euro rises, the reverse happens. Either way the investment's dollar value now moves with the asset, not with the exchange rate. Currency swaps, futures and options can do the same job.

In the language of hedging, this brings the position's exposure to the exchange rate close to zero, the same idea as a delta-neutral position applied to currencies.

A worked example

A fund that reports in dollars buys 1 million euros of short-term bonds when one euro buys 1.10 dollars, so the position is worth 1.1 million dollars. At the same time it agrees to sell 1 million euros in three months at close to that rate. Over those three months the euro slides to 1.00 dollar. The bonds are still worth 1 million euros, but that is now 1 million dollars, a loss of about 100,000 dollars from the currency alone. The forward contract gains close to 100,000 dollars and offsets it. What the fund keeps is the bonds' own return, adjusted by the cost of the hedge.

What hedging costs

A forward rate is usually not today's exchange rate. It reflects the gap between the interest rates of the two currencies, so a hedge can add to or subtract from the return depending on which currency pays more. Hedges also have to be rolled: a three-month contract must be replaced when it expires, and each roll has trading costs. For widely traded currencies those costs are small; for thinly traded ones they can be large, and a hedge can be hard to find at all.

Hedged vs. unhedged

Many funds come in two versions. A hedged version aims to deliver the asset's return in the investor's own currency. An unhedged version adds currency exposure, which helps when the home currency weakens and hurts when it strengthens. Neither is better in general: hedging gives up the chance of currency gains in exchange for results that are easier to predict. Onchain products that are measured in dollars, such as a synthetic dollar, face the same choice for any position held outside the dollar.

Risks and limits

• A hedge covers the amount it was sized for. When the asset's value changes, the hedge has to be resized, and until then part of the position is exposed.
• The other side of the contract has to pay when the hedge is in profit, so counterparty risk remains.
• Hedging costs change over time, and rolling a hedge in a stressed market can be expensive.
• A currency hedge removes exchange-rate risk, not the risk of the asset itself. A hedged bond can still default.

Tori Finance runs a delta-neutral strategy that earns from global markets, with positions hedged to USD. Hedging to USD means the strategy aims to keep exchange-rate moves from changing the dollar value of its positions, so its results are measured in dollars. The yield that strUSD accrues is variable and never guaranteed.