David McNay
- The primary objective of currency hedging is mitigating FX risk, and it’s important to note that hedged returns are not the same as local-currency returns.
- Currency hedging alters the risk-return profile of an asset class; we show that a USD-denominated investor who hedged offshore currency exposure in the FTSE World Government Bond index (WGBI) achieved a higher return for a lower level of volatility over decade to end-September-2025.
- In an FX forward, the party with the higher local rates typically pays an implied yield; the other earns it. This “carry” (or cost of hedging) is not static creating opportunities for tactical investors.
Recently we’ve heard it repeated that: “hedged returns are just the same as local currency returns” which was a reasonable heuristic, but is no longer the case. Recent fragility in the US dollar means it is ever more important to understand what hedging is, and is not, which is the focus of this insight, the first in a series on currency hedging.
First, let’s make the subtle distinction that the objective of currency hedging is mitigating currency risk, not achieving local currency returns. The simplest method of hedging is an FX forward contract, locking in a future rate. Our CFA textbooks remind us that our forward rate should be constrained by “covered interest rate parity”, but for those of us whose textbooks maybe gathering dust, we illustrate the mechanism below in Exhibit 1.
Exhibit 1: Simplified example of Covered Interest Rate Parity
Source: FTSE Russell. Note: Simple illustration. Assume a US investor has $100 to finance a birthday present in 12months. She could place that in a fixed deposit earning 5%, giving her $105. Alternatively, she may convert her dollars to Euros at the spot rate of 0.85, giving her €85, and she earns 2.5% in Euro for a final holding of €87.13. Suppose USDEUR spot moves to 0.80, when converted back to dollars she now has $108.91; or the rate may shift to 0.875 and she is left with $99.57… short her present funding target. Please see the end for important legal disclosures. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
The key intuition being that whenever two parties enter an FX forward there is a form of “carry” paid via the interest-rate differential.
A simple rule of thumb:
If your local rates are higher than offshore rates, then you earn carry; thus if your local rate is lower, you pay carry.
In practice interest-rate differentials represent the implied-carry from forwards. Contracted rates depend on many factors, like the rates a broker can achieve, typically via their treasury department, as well as overall risk appetite. To demonstrate, in Exhibit 2 we show the difference between the 12-month SOFR and €STR[Note1], and the 12-month implied forward rate.
Exhibit 2: Rate differential between the 12m SOFT and ESTR vs. the forward-implied rate
Source: FTSE Russell and LSEG; data from31-October-2019 to 30-September-2025. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Why does this matter?
In short, this matters because,
- currency hedging affects asset risk-return characteristics, and
- cost of hedging is time-varying, meaning the opportunity set changes, making it more or less appealing as a tactical opportunity.
Exhibit 3 plots the rebased returns of the FTSE World Government Bond Index hedged and unhedged. During most of the post-GFC period the two series track one another, although the unhedged index is visibly more volatile. Post Covid there is a noticeable performance disconnect as regional dynamics created divergences in interest rate policy.
Exhibit 3: FTSE WGBI Rebased in USD, hedged and unhedged
Source: FTSE Russell and LSEG; data rebased to 31-Aug-2015 and to 30-Sept-2025. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
But better performance should not be the key takeaway, which is the reduction in volatility. Annualised volatility hedged was 3.8% vs. 6.7% unhedged over the 10-year period ending September 2025. This result is well known in the bond space, but in a future post we will discuss how this relates to equities and multi-asset portfolios.
Exhibit 4: Implied yield paid to a US investor from a 12m FX forward
Source: FTSE Russell and LSEG; data to 30-September-2025. Note: For each currency, the vertical capped lines are the “whiskers” showing the 10-year [IR1] range of implied carry; shaded boxes highlight the inter-quartile range, with the horizontal line identifying the median. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Regarding time variation, Exhibit 4 shows the 12-month implied carry[Note2] to a US investor, contextualised with the 10-year range. A US investor who had chosen to hedge their Canadian Dollar currency risk was earning +1.4% per annum for taking away the CAD risk; about the 93rd percentile where the median carry was +38bps.
That is not a tactical recommendation! It is an observation that currency exposure is frequently an afterthought in the portfolio construction process. The deliberate use of hedging can reduce risk in portfolios and in some cases may even be accretive to performance.
Sources
[1] Secured Overnight Financing Rate (SOFR) and Euro Short-Term Rate (€STR) are measures of short-term financing rates in the wholesale market. They have replaced LIBOR and EURIBOR as the main reference benchmarks for pricing of many derivatives. | Back to Note 1
[2] Implied by the WMR closing 12-month forward rate. | Back to Note 2
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