Should You Hedge Foreign Exchange Risk

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Since foreign exchange risk does add to the dollar risk of holding foreign securities, it could be desirable for an investor in foreign markets to hedge against currency movements. Currency hedging means entering into a currency contract that offsets unexpected changes in the price of foreign currency relative to the dollar.

Although currency hedging seems like an attractive way to offset exchange risk, in the long run it is often unnecessary and could be detrimental. This is because the cost of hedging depends on the difference between the interest rate in the foreign country and the domestic country, and that could be high.

For example, the British pound depreciated from $4.80 to about $2.00 over the past century. But since British interest rates were, on average, substantially higher than interest rates in the United States, the cost of hedging exceeded the depreciation in the pound. Thus investors' dollar returns were higher if they owned British stocks without hedging them than their dollar returns if they owned British stocks and paid to hedge them.

Furthermore, for investors with long-term horizons, hedging currency risk in foreign stock markets is not important. In fact, there is some evidence that in the long run, currency hedges might actually increase the volatility of dollar returns.9 In the long run, exchange-rate movements are determined primarily by differences in inflation between countries, a phenomenon called purchasing power parity. Since equities are claims on real assets, their long-term returns have compensated investors for changes in inflation and thus protected investors from exchange-rate risk. Therefore, it is not worth the cost for long-term stock investors to hedge their currency risk.

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