Friday, 6 May 2016

How to manage currency risk

How to manage currency risk

Currency risk is a fact of life for many expats. Many investors find it tempting to ignore currency risk, believing that it will all “even out in the end” but this is not an option for most families who need to draw down funds from their investment portfolio or their pensions. Significant currency risk needs to be managed actively and families should balance currency exposures in the same way they balance asset class exposures.

Understanding Currency Risk

Defining what “currency risk” means to each person is important. Someone living in Cyprus and spending Euros but drawing their income from their investments or pensions in Sterling has significant currency risk. For a family with a long term currency spend bias to the euro, for example, someone relocating or retiring to Cyprus from a non-euro country, an appropriate currency spread might be 50% euros, 30% Sterling, and 20% other currencies (like US$). In contrast, a family who thinks and spends globally might adopt a more diversified basket of currencies as a target. Those that plan to stay in Cyprus for less than 2 years would be well advised to retain most of their assets in the original currency.

Managing the Risk

In the past, families tended to manage currency risk by investing in assets with the same currency profile as the families’ spending or long-term liabilities. Traditionally many UK families would invest predominantly in UK equities and sterling bonds to minimise any mismatch. Any overseas investments would be seen as ‘diversification,’ and the foreign currency exposure would form part of this diversification. As the world has become more global, European investors have tended to invest more globally. For a portfolio with global bonds, global equities, hedge funds, and private investments, US dollar exposure has increased markedly as a proportion of total assets.

While some European family investors see this additional US dollar exposure as a risk, others might like the US dollar exposure, seeing it as a “safe-haven” currency that will diversify overall portfolio risk when markets are very volatile. The value of this type of currency diversification was demonstrated in 2008. When markets headed south and sterling nosedived, having unhedged US dollar assets provided a useful counterweight to a UK family’s portfolio.

Hedging Currency Exposure

For families who want to preserve the underlying exposures of the portfolio but have a significant mismatch between currency exposures and liabilities, considering currency hedging makes sense. There are a number of ways to change the currency exposure of a portfolio. Two of the most popular include using hedged share classes and currency forwards.

The easiest way to hedge unwanted foreign currency exposure is to invest in vehicles with hedged share classes (i.e. Euro based international bond funds). These are commonly available for most major currencies, particularly for global bond funds. The main advantage of this approach is the operational simplicity for the family. The main disadvantage is that it can be more costly.
If the appropriate hedged share classes are not available, or

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