Currency hedging is a powerful tool, offering foreign investors access to new opportunities, providing returns very similar to those of local ones. However, it also has some disadvantages to consider.

In this post we will explain how passive hedging could transform the original currency risk problem into a different one: **dealing with the cash flows from hedging**.

Going back to the **equation for the return on a foreign asset**:

\( R = (1 + R_{asset}) \cdot (1 + R_{spot}) – 1 = R_{asset} + R_{spot} + R_{asset} \cdot R_{spot} \)

**EUR risk case – Unhedged**

We are analyzing the case of a US investor who decides to put 1M on EUR assets:

- Participating in a portfolio in EUR: 500.000€
- Buying a property sited in Europe: 500.000€

Total return will depend on the assets returns as well as on the EUR/USD variation. Let’s assume that neither the portfolio nor the property changed in value during 2021. In other words, the USD exposure was constant throughout the year. In this way, we isolate the currency impact. Otherwise, we would need to pay attention to the** Asset Value Uncertainty**.

\( R = 0.00\% + R_{spot} + 0.00\% \cdot R_{spot} = R_{spot} \)

As **Euro depreciated against the Dollar** in the past year, by around -8%, both assets experimented losses:

Normally, currency risk is an **unintended extra risk** that must be taken in order to benefit from the desired overseas investments. To avoid it, the most straightforward solution is to hedge.

**EUR risk case – Hedged**

A **forex hedge** consists of holding the opposite position in the currency cross in order to offset the movements that occur. Forward contracts are the typical instrument for it. A forward contract consists of locking a price to execute a transaction at a predetermined date in the future.

Hedging is the resolution to avoid potential losses in exchange for foregoing potential gains. **The “cost” of hedging** rests on the forward prices, which are determined by the** Interest Rate Differential** between the two currencies involved. Although it is called a cost, in reality it can be either negative or positive. On top of this result, transaction fees must be added and also management fees, if outsourcing the hedging service.

Therefore, the forward transaction will return exactly the same result as the currency exposure experienced, but with the opposite sign, plus the interest rate differential and the fees. This is true as long as the hedge is implemented properly. It is easy in our example where the exposures did not change, **but more complex in real life**.

\( H =\ – R_{spot} + R_{swap} + R_{fees} \)

During 2021:

We assumed 1M forwards and -0.05% in terms of costs (transaction fees + management fees) to compute the shown return. We can then cancel the result of the EUR exposure with that of the hedge:

\( R + H = R_{asset} + R_{asset} \cdot R_{spot} + R_{swap} + R_{fees} \)

In our case:

\( R + H = R_{swap} + R_{fees} \)

**Realized PnL**

Nevertheless, it should be noted that the hedging result is settled, realized, (monthly frequency in our simulations) and **can only be counterbalanced with another realized result**.

In the portfolio example, it would mean using the hedging result to increase the investment in the portfolio back to its original amount of 500,000. This transaction would actually have to be carried out on a monthly basis. It is the term of the forwards that determines the settlement periods. By the end of the year, the value would remain intact and there would even be an extra positive cash flow of about 3,400 euros, resulting from favourable rate differential minus fees.

However, the illiquid real estate would be valued at approximately 463,000 euros and, apart from that, there would be a cash flow of about +40,400€ at the end of the year. There is no way to buy an extra room to keep the investment intact month by month. Perhaps this particular situation doesn’t pose a big problem, as the monthly cash flows are mainly positive. But let’s now look at an opposite scenario.

In 2021, hedging produced a slightly positive PnL, making it a much more positive scenario for those who decided to hedge. This was the result of a positive -EUR/USD and rates in favour that clearly offset the costs. Of course, this is not always the case.

**USD risk case – Hedged**

We just turn the currencies around to find an opposite scenario. Let us now think about a European investor who decided:

- To participate in a USD portfolio: 500.000$
- To buy a house in EE. UU.: 500.000$
- To hedge their USD risk

For this European investor, both the interest rates and the – USD/EUR are negative:

Those who decided to hedge USD in 2021 missed the opportunity to increase their USD investment. In addition, they had to pay both the cost and the rate differential. Here are the numbers for our examples:

The passive hedging strategy returned this time a negative cash flow. It made up of a negative – USD/EUR, a negative differential and negative fees:

For the portfolio, they could disinvest the proportion due to the increase in the USD. It would return the portfolio to its original amount. Besides, it would result in a positive cash flow that cancels out with the hedge. Thus, they would lose the USD appreciation that the hedged investor was willing to forego. Not only did they lose the opportunity to make a profit, but they also had to bear the costs of the rates differential and fees.

But what should they do with the real estate? As they cannot sell a portion of the house, they should afford all the negative cash flows on their own. The amounts total -44,500$ as of the end of the year and may well present a problem. **The hedging turned the currency risk into a cash flows risk problem.**

**Conclusion**

When the currency risk derives from an illiquid exposure, the volatility of the cash flows that hedging transactions will produce can be a good reason to decide not to hedge systematically.

Other alternatives, such as **not fully hedging** or **active hedging**, provide more appropriate currency risk management in these particular situations.