Currency risk

ETF hedging
Can ETFs be used to hedge against currency risk?

Hint

Answer

Yes, currency-hedged ETFs are designed to mitigate the impact of foreign exchange movements on international investments. They use derivatives to hedge against currency risk, offering protection against fluctuations in exchange rates.

Currency-hedged ETFs are particularly useful for investors looking to diversify internationally without taking on additional currency risk. These ETFs can be more complex and might have higher costs due to the use of derivatives for hedging.

Let's consider a practical example to illustrate how currency-hedged ETFs can be used to hedge against currency risk, particularly for investors with international investments. Imagine you are an investor based in the United States, and you want to invest in European stocks. However, you are concerned about the potential impact of currency fluctuations between the Euro (EUR) and the U.S. Dollar (USD) on your investment.Β Concerns are the following:
  • When you invest in European stocks, your investment value will be affected not only by the performance of the stocks but also by the EUR/USD exchange rate.
  • If the Euro weakens against the Dollar, your investment, when converted back to USD, could lose value, even if the European stocks perform well.
Solution - Currency-Hedged ETF:
  • You decide to invest in a currency-hedged ETF that focuses on European stocks.
  • This ETF invests in a range of European stocks, providing exposure to the European market.
Hedging Mechanism:
  • Alongside holding European stocks, the ETF uses financial derivatives (like forward contracts or options) to hedge against currency risk.
  • These derivatives are designed to offset any losses (or gains) caused by changes in the EUR/USD exchange rate.
How It Works:
  • If the Euro Strengthens: The increase in the value of the European stocks (when converted to USD) is partially offset by a loss on the derivatives, keeping the overall value more stable.
  • If the Euro Weakens: The decrease in the value of the European stocks (in USD terms) is offset by gains in the derivatives, again stabilizing the overall value.
Outcome:
  • By investing in this currency-hedged ETF, you maintain exposure to European stocks while mitigating the impact of EUR/USD exchange rate fluctuations on your investment.
  • Your investment is more insulated against currency risk, allowing you to focus more on the stock performance rather than worrying about currency movements.