What is currency hedging?

Currency hedging is designed to reduce the impact of exchange rate fluctuations on investments that are traded in another currency, such as US shares or international exchange traded funds (ETFs).

Hedging can be likened to an insurance policy that limits the impact of foreign exchange risk and can be used by investors and businesses that have international holdings.

Currency risk

You’ll be exposed to currency risk if you invest in share markets outside of Australia, either buying international shares directly or through an exchange traded fund, for example.

ASX-listed international ETFs are denominated in Australian dollars but the underlying investments in the fund, such as US shares for instance, are traded in another currency.

This means that exchange rate movements will affect the value of your investment, which could have a positive or negative impact on your returns.

Example: If you bought A$10,000 of units in an ASX-listed ETF that tracks a US share market index, while the US dollar was worth exactly the same as the Australian dollar (A$1 = US$1), you would get US$10,000 worth of units (ignoring brokerage fees).

If the Australian dollar strengthens to be worth US$1.20 by the time you sell your investment, you will only get back A$8,333, assuming no change in the value of the underlying fund holdings.

Conversely, if the Australian dollar weakens to be worth US$0.80 by the time you sell your investment, you’d get back $12,500, assuming no change to the value of the underlying fund holdings.  

You would also be exposed to these exchange rate movements if you invest directly in international shares or in certain Australian companies that derive a lot of their earnings from overseas.

It’s therefore important to bear in mind that the return on your investment from both capital gains and distributions would be determined not only by the performance of the underlying assets but also by exchange rate movements.

Hedged ETFs

To alleviate this currency risk some ASX-listed international ETFs are ‘hedged’.

Hedged ETFs enter into forward foreign exchange contracts with another party to essentially lock in a set exchange rate for the future to reduce the impact of currency fluctuations.

A downside, however, is that if an international ETF is hedged it removes some of the diversification benefits of investing in assets of another currency and may increase your dependence on the Australian economy.

Currency risk may become more complex in the case of multi-market ETFs, which have exposure to a variety of currencies because different currencies don't always move in the same direction or by the same amount.