A beginner-friendly guide to currency hedging for—what it is, how it works, when to apply it, and what risks it helps manage.
What is currency hedging? A beginner’s guide to hedged and unhedged investments
Currency hedging is a strategy used to help reduce the risk of exchange rate fluctuations. It is commonly used by investors with overseas assets or companies engaging in international transactions. By using currency hedges properly, you can limit potential losses caused by unfavourable currency movements.
This article explains the meaning, purpose, and mechanics of currency hedging, along with common questions frequently asked by beginners.
What is currency hedging?
Let’s begin by understanding the purpose and mechanism of currency hedging.
Purpose of currency hedging
The value of foreign assets can fluctuate depending on exchange rate movements.
For example, if you hold foreign equities and the Singapore dollar (SGD) weakens against other currencies, the value of those SGD-denominated assets will increase.
Conversely, if the SGD strengthens, the asset value declines.
Currency hedging is a strategy designed to help reduce this currency risk thereby limiting the negative impact of exchange rate fluctuations on your investment value.
While you may miss out on potential gains from a weaker Singapore dollar, hedging helps offset your losses during currency appreciation.
Mechanism for currency hedging
Currency hedging is typically implemented through transactions such as forward contracts or currency swaps, which fix exchange rates in advance.
In the case of investment portfolios, fund managers often use these mechanisms on behalf of investors to manage currency risk.
A forward contract is a financial transaction that locks in a specific exchange rate at a future date.
This ensures that when you repatriate your foreign investment, it converts back into Singapore dollars at a pre-agreed rate, minimising currency losses.
However, currency hedging does involve costs.
These are primarily due to the interest rate differential between Singapore and the foreign jurisdiction: the wider the gap, the higher the cost.
Differences between hedged and unhedged products
You'll often find hedged and unhedged products when choosing foreign currency assets such as overseas equities or trusts.
Hedged products help reduce the impact of FX rate fluctuations but come with additional costs.
Conversely, unhedged products are fully exposed to exchange rate movements, which can result in greater volatility in returns.
Some products may apply partial hedging to balance the risks associated with currency appreciation and depreciation.
Pros and cons of hedged investments
Advantages
- Reduced impact of currency fluctuations on investment returns.
- Investors can focus on analysing the core investment rather than foreign exchange trends.
- Particularly useful for those who prefer stable and predictable returns.
Disadvantages
- No benefit from currency movement (e.g. if the Singapore dollar weakens).
- Hedging costs may reduce overall returns, especially if the interest rate differential is high.
Pros and cons of unhedged investments
Advantages
- Potential to gain from a weaker Singapore dollar.
- Currency gains may offset declines in the underlying asset value.
- No additional cost incurred from hedging.
Disadvantages
- Full exposure to currency losses if the Singapore dollar strengthens.
- Investors must analyse both asset fundamentals and currency movements.
- May result in increased risk and complexity compared to domestic investments.
Frequently asked questions
Generally, the decision should be based on your view of exchange rates and level of risk tolerance. Here are a few considerations:
| Hedging choice | When to choose |
|---|---|
| Unhedged | You expect the Singapore dollar to weaken |
| You are comfortable assuming potential currency losses | None |
| Hedged | You expect the Singapore dollar to strengthen |
| You wish to remove exchange rate considerations from your investment decisions | None |
Hedging is often more suitable if you are a beginner and prefer to avoid monitoring currency movements.
You will not benefit from currency movements.
Typically, if the Singapore dollar weakens, foreign assets increase in value when converted back.
However, currency hedging neutralises any profit, as its purpose is to help reduce the negative effects of exchange rate movements.
Currency losses can be limited.
However, if the appreciation is minimal, the hedging cost may exceed the avoided loss—meaning an unhedged investment could have been the better option in hindsight.
Summary: What is currency hedging?
Currency hedging is a tool to help mitigate the risks of exchange rate fluctuations and protect your investments from losses due to unfavourable exchange rate movements.
It helps reduce the need to monitor currency movements closely, but it may mean you miss out on potential gains from currency movements.
Deciding between hedged and unhedged products is advisable based on your risk tolerance and investment goals.
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This article and its contents are intended for educational purposes only and should not be considered trading advice.
