Julian Whitaker
David McNay, CFA
Key takeaways
- Last week we saw a significant spike in the Japanese yen following a joint Japan/US intervention in the currency market.
- It is reasonable to expect further near-term volatility in the spot rate.
- Historically, currency-hedged returns have performed better than unhedged returns during periods of heightened USD/JPY spot volatility.
In “Time for an intervention”, we noted that the coordinated late-July intervention by the US and Japanese authorities had weaponised volatility, resulting in a 5 standard deviation spike in the dollar-yen spot rate. The potential for a further large directional move in the yen implies that investors should be deliberate about their FX exposure.
Figure 1: USD/JPY Spot, rolling 20d spot volatility and volatility change since 2016.
Source: FTSE Russell, data to August 9, 2026. Past performance is not a guide to future returns. Please see the end for important legal disclosures.
That isn’t to say that investors need to change their strategies. Conventional wisdom is that foreign equity exposures should be unhedged and that currency movements wash out over time. In other words, investors should accept an implicit long position in international currency.
However, given recent volatility, investors should ask themselves explicitly if they want to assume the FX risk. Do they want to hedge it? Or should they take a more ‘neutral’ view and use a partial hedge?
How FX volatility has affected Japanese equity returns
Following the recent spike in the yen, it is reasonable to expect further short-term volatility in the USD/JPY currency pair. There are arguments for the yen both strengthening and weakening: a cheap yen, recent Japanese rate hikes and the possibility of continued FX interventions support a bullish case; persistent yield differentials and expansionary fiscal policy in Japan favour the bearish case.
Looking top-down at the history of this important currency pair and comparing past hedged and unhedged returns, we can contrast returns during periods of low, medium and high spot rate volatility.
Here, we define low-, medium- and high-volatility periods by comparing the rolling 25-day realised volatility of daily spot returns to the 5-year trailing average (with the medium-volatility band being ±0.5 standard deviations around the trailing baseline).
In the chart, the blue shaded areas mark periods of high volatility, the white areas mark periods of medium volatility and the green areas mark periods of low volatility.
Figure 2a: Spot volatility with trailing 5Y mean categorising low and high vol periods.
Source: FTSE Russell, data to August 9, 2026. Past performance is not a guide to future returns. Please see the end for important legal disclosures.
Over the observation period, the number of low-volatility observations (47% of the sample) was higher than the number of medium-volatility observations (33%), which in turn was higher than the number of high-volatility observations (20%). This is representative of the clustering of volatility we typically see when observing financial market returns.
Figure 2b: Average annualised return of hedged vs unhedged FTSE Japan Index during low- and high-volatility periods defined in Figure 2a.
Source: FTSE Russell, data to August 9, 2026. Past performance is not a guide to future returns. Please see the end for important legal disclosures.
How has this affected the returns from Japanese equities for a US dollar-based investor? Since 2016, dollar-hedged Japanese equities have delivered higher average returns than their unhedged counterparts across all three volatility regimes.
The difference was particularly pronounced when USD/JPY volatility was elevated: in the high-volatility regime, annualised returns averaged 23.4% for the hedged index, compared with a 5.4% return from the unhedged index.
This does not imply that higher volatility causes hedging to outperform per se. Hedging profit (or loss) arises from the spot rate moving more (or less) than the carry implied by the hedging instrument. However, we can conclude that over this period the historical benefit from hedging was considerably greater when spot foreign exchange volatility was elevated.
Conclusion
Currency hedging is a valuable tool for international investors. Since the yen peaked in 2011, foreign investors in Japanese assets would have benefited from hedging, either from the perspective of return enhancement or volatility reduction. As well as removing yen currency risk, foreign investors earned positive carry from hedging, reflecting the large interest rate differential between the Bank of Japan’s and the Federal Reserve’s policy rates. While this gap has narrowed, it continues to exist.
Considering recent FX movements, our analysis implies that currency hedging has proved especially valuable during periods of heightened spot volatility, highlighting the importance of investors managing their currency exposure in international portfolios explicitly, not implicitly. In a follow-up piece, we will explore the application of partial hedge ratios to achieve a variety of investment objectives, including volatility reduction. We will also broaden the analysis to include a wider selection of currency pairs and equity portfolios containing multiple constituent currencies.
Disclaimer
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