Which Currency Exposures May Make Sense
One rationale for assuming currency risk in foreign equities that I often hear is that investors want diversification in the event of a weakening U.S. dollar. I believe this is a worthwhile goal, but why not target more directly currencies with the strongest potential fundamental prospects? Those currencies come from countries with faster economic growth, higher real interest rates, younger populations and lower levels of government debt. In my view, the euro does not qualify as one of these fundamentally strong currencies, but many emerging market currencies currently do.
Minimal Cost of Hedging the Euro Due to Small Interest Rate Differences
The cost of hedging currencies for U.S. investors is most directly impacted by the local interest rate of that market compared to the U.S. interest rate. Brazil, for instance, has a high cost of hedging the real—given the currently very high interest rates in Brazil compared to U.S. interest rates.
But interest rates in Europe and the United States are currently at very similar levels. This fact contributes to a lower cost of hedging the euro’s movements against the U.S. dollar.
Conclusion
Currency hedging strategies have come in focus in 2013 as the Japanese yen has weakened substantially and Japan’s equities have appreciated almost in lockstep with the yen’s depreciation. In a number of other markets, such as Europe, hedging currency has a different, yet equally important, motivating factor: it helps reduce volatility. The euro is a prime candidate for hedging, in my view, given all the uncertainty that still surrounds the eurozone.
WisdomTree Europe Hedged Equity Fund (NYSEArca: HEDJ)
Jeremy Schwartz is director of research at WisdomTree Investments (NasdaqGM: WETF). This post was republished with permission from the WisdomTree blog.
1Risk: Standard deviation, which measures the dispersions of actual returns about an average return during a specified period. Higher values indicate a higher chance of being further away from that average value. Risk, volatility and standard deviation are used throughout this piece to mean the same thing.
2For U.S. investors in international equities, the standard deviation of the underlying equity, as well as the standard deviation of the currency, contributes to the total standard deviation for the investment.