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To hedge or not to hedge? Things to consider when hedging currency

Looking at the question “hedged or unhedged” there are arguments both ways, mostly based on how the Australian dollar performs.

In simple terms, if you think the Australian dollar is going to go up in value against other currencies, you are going to see your offshore assets drop in value by local standards. If you buy US dollar assets when the $A is at US70c and our dollar rises to US80c, and you sell those assets, you are going to be 14.2 per cent behind in Australian dollar terms.

Insurance

Conversely, if you buy them when our dollar is at the higher level and sell when it goes into one of its periodic dips to, say, the US70 cent level, you are going to be ahead by 12.4 per cent.

The difference between those two percentages, 12.5 and 14.2, is that they represent the same gain or loss but the calculations are respectively based on 80 cents and 70 cents.

Hedging is a form of insurance and like all insurance policies it has a cost. As one expert put it, “hedging is not a money making strategy”. It’s more a way of avoiding loss.

How do you hedge? You can open an account with one of the many forex trading companies and use a strategy such as buying a forward contract or an option. Some global investment products are also offered wit hedging in place.

But you would need to do your homework on the subject first, as currency hedging was designed for professionals moving big amounts of money around.

Natural hedge

Lateral thinking retail investors can always look to buy an asset that is a natural hedge.

Say you were worried about the Australian dollar rising and making your offshore holdings less valuable in $A terms. If you could find an $A denominated asset that’s going to benefit from a lift in our dollar, say shares in an outbound tourism business, that would be a natural hedge.

But, a word of warning: such a strategy could still be dangerous because you can’t time lifts in sharemarket valuations with any accuracy.

A simpler strategy for retail investors who are worried about the Australian currency going up is to sit tight on the investment, and take a holiday exploiting the stronger Australian dollar as they do so. They won’t make any money but at least they will enjoy spending it. Ask anyone who went to the USA in 2014 and enjoyed exchange rate parity between the two currencies.

 

This article is part of our investing starter series. You can read more of this series here.

These are the views of the author, Andrew Main. This is general in nature and does not take into account your personal circumstances.