Currency risks, part 2: Currency hedging of international equities

The recent large moves in the US dollar have brought the idea of currency hedging to investor attention. Currency hedging is often ignored when discussing international equity investments but this recent period of unusual currency moves (discussed in another insight) reminds us of the impact of currency risk. In this insight, we give a gentle review of currency hedging, focusing on hedging equity exposures. 

This note discusses the intuition of currency hedging (or simply “hedging” in this article) and does not get into the specifics of hedging costs. Hedging relies on a market for currency forwards that are traded to remove the impact of currency moves, which means that only markets with liquid forwards will allow currency hedging at reasonable prices, and for some markets (e.g. some emerging markets) there is no practical way to hedge currency movements. 

In this note we show that the impact of currency hedging on volatility depends on the correlation of the investment country’s equity and currency returns, and so can vary by country. In general, this correlation is positive, so currency hedging reduces the volatility of an international equity investment. However, the US and Japan have negative correlations between their equity and currency returns, and so currency hedging investments in those countries would be expected to increase investment return volatility.

Currency hedging of equity investment, as is implied by the term, is an action taken to reduce the risk of making an international equity investment. Investors invest in equities because they believe that the equity investment will appreciate in value over time. However, if the investment is an international investment in a country with a different currency, then the return on the equity investment must be converted back into the investor’s home currency when the return is realized, and that means that there is an additional currency return due to the movement in exchange rate with the home currency. This additional currency return can increase or reduce the total home currency return, depending on the direction of the currency return. 

Exhibits 1 and 2 show hypothetical examples where the foreign currency moves in the same direction as the equity return and in the opposite direction as the equity return, respectively. 

While these examples are hypothetical one-period returns, what is important is the relative size of equity and currency returns over time. We can look at the volatility of returns to get an idea of the relative magnitude of these returns over time. Exhibit 3 show the 10-year volatility (annualized standard deviations of return) for select equities and currencies. 

In general, currency volatility is lower than equity volatility everywhere, but it is much higher in some countries. All of the currency returns in this insight use the USD exchange rate (e.g. Euro to USD exchange) except for the USD, which uses the DXY trade-weighted dollar index. 

When thinking about taking on equity and currency risk, it should be noted that while equities (and fixed income) do have a risk premium and are expected to have a long-term payoff, currencies do not and so they just add expected volatility. Exhibit 4 shows annualized equity and currency returns over the last 10 years. In all cases, we see that equity returns have been positive, but currency returns have ranged from slightly positive in the US and Eurozone to very negative in Turkey, which has gone through a period of high inflation. The point is that long-term currency investment adds expected volatility without adding any expected return. 

While investing in currency does imply taking on risk, the impact of adding currency exposure to an equity exposure depends on the correlation of the equity and currency returns. Exhibit 1 above gives an example in which the two returns move together, or have a positive correlation, and we would expect this would increase the volatility of the combined equity-currency position. However, if the correlations are negative, as shown in Exhibit 2, currency exposures could reduce overall volatility since the currency move would be expected to dampen the equity returns, both positive and negative. 

Exhibit 5 shows the correlation of selected country equity index returns with their currency returns over the 10 years ending 30 April 2025, sorted by correlation. We can divide these countries up into several groups, with perhaps a few leftovers: 

• The high correlation countries are dominated by emerging countries or countries that are primarily resource exporters. It is likely that these countries’ equity markets and currencies are dominated by flows into the country. The marginal investor is a foreign investor that invests in the equity markets (and the currency) when prospects for the country look good and pulls money out when prospects deteriorate. 
• The positive but low correlation countries here are dominated by the Eurozone countries (plus the UK) that have a positive but loose connection between flows into that country’s equity market and flows into the currency. In the case of the Eurozone, because it is a multi-country currency block, equity markets are quite diverse and so currency impacts are muted because equity flows are averaged across many countries. 
• Finally, the only countries here that have negative correlations are Japan and the US. In the case of Japan, the negative correlation has long been observed, and it may be that the marginal equity investor is Japanese who understands that a depreciating currency helps the terms of trade for Japanese exporters and so bids up the equity market when that happens. Finally, US government bonds have traditionally been considered safe-haven assets, and when global risk aversion rises, there are flows into US assets and the US dollar by investors globally. However, during the same period of risk aversion, domestic investors often pull money out of the equity market and invest in bonds, which creates the negative correlation between US equity and currency returns.

The expected impact of currency hedging on investments, then, depends on a couple of factors: 

• The volatility of the currency and equity returns at the location of the investment. 
• The correlation of the investment currency return to that of the equity return. 

This means the impacts of currency hedging are not general but depend on the location of the investor and the investment. For example, 

• US investors investing in a developed resource exporter such as Norway will see increased volatility of an unhedged investment and so could reduce their return volatility by hedging. They may consider hedging the currency exposure. 
• Similarly, investors in emerging markets will generally see considerably higher volatility with unhedged investments, but hedging emerging currencies may be prohibitively expensive, and so they may have to consider the investment as all-in-one when making investment decisions. 
• US investors investing in Eurozone equities can expect to see only a small reduction in volatility if they hedge because the correlation of the Euro with each of the Eurozone’s country indices is quite low. 
• Foreign investors investing in the US or Japan, however, generally expect to see lower volatility without hedging and may be happy to forgo hedging. This also applies to investments that are dominated by US equities such as global cap-weighted equity indices. 

In addition, there may be investors that have a particular view on the direction of a specific currency, in which case they could hedge opportunistically to pick up the currency impact on an equity portfolio. However, there may be more efficient vehicles for investing directly in currencies. 

Finally, the discussion here is based on long-term correlations, average returns, and volatility. Currencies can move sharply and deviate from expected patterns, particularly in the short run. Foregoing hedging allows those shocks into the portfolio, whereas hedging removes the currency risk and confines the risk to the intended equity portfolio risk. For example, while the US has had a negative correlation between its currency and equity returns, recently the correlation has been positive, and so currency hedging would have reduced the volatility of those investments.

This family has country sub-indices, so for example the USA equity investment refers to the FTSE USA index, and so on.