Currency Hedging for a Global Bond Portfolio
A UK charity has a £50 million global bond portfolio and a known sterling liability in seven years. The portfolio is 60% US dollar, 25% euro, and 15% Japanese yen. Local-currency yields are 5.4% in USD, 2.8% in EUR, and 0.8% in JPY. The weighted unhedged yield is about 4.9%. Hedging the currency exposure back to sterling would lock in a yield of about 4.1% because of forward points. The portfolio's local bond volatility is 5% annualised, currency volatility against sterling is 8%, and the correlation between bond returns and currency moves is about 0.1. The investment committee is split: one member argues that hedging gives up 0.8% a year for no reason, while another says the charity should hedge everything because the liability is in sterling. The charity's spending is sterling-based and the liability is fixed in sterling terms.
1. Explain whether the 0.8% hedging cost is a free lunch or a risk reduction.
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The 0.8% is not a fee in the ordinary sense; it reflects the interest-rate differential embedded in forward exchange rates. If sterling interest rates are lower than foreign rates, the forward rate typically implies a cost of hedging, but the unhedged investor is expected to earn the higher foreign yield partly because the currency is expected to depreciate. Under uncovered interest parity, the expected sterling return from the unhedged position should be similar to the hedged return, but the unhedged return has much wider dispersion. Neither position has a guaranteed higher expected return.
For a charity with a sterling liability, the relevant question is risk, not the highest available yield. Hedging converts foreign-currency bond returns into sterling returns and removes the currency component from the funding ratio. Giving up 0.8% of yield may be worthwhile if it removes several percent of volatility and reduces the chance of a shortfall at the liability date.
2. Using the volatility and correlation data, compare the risk of hedged and unhedged portfolios.
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Approximate unhedged volatility as the square root of: bond volatility squared + currency volatility squared + 2 × correlation × bond volatility × currency volatility. That is √(5² + 8² + 2 × 0.1 × 5 × 8) = √(25 + 64 + 8) = √97 ≈ 9.85% annualised. The hedged portfolio's volatility is approximately the local bond volatility, around 5%, assuming the hedge is effective and ignoring basis and counterparty risk.
Hedging therefore roughly halves volatility while reducing the yield from about 4.9% to 4.1%. For a sterling liability, that is a material improvement in risk-adjusted funding outcomes. The unhedged portfolio is not necessarily wrong for an investor with no sterling liability and a long horizon, but this charity is not in that position. The correlation of 0.1 is low, so currency adds risk rather than diversifying the bond exposure.
3. Recommend a hedge ratio and an implementation approach.
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Recommend a strategic hedge ratio of 75–100% of the currency exposure, with the exact level set by the charity's funding policy and liquidity needs. For a fixed sterling liability, a high hedge ratio is defensible because the purpose is to stabilise the sterling value of the assets. A 100% hedge is simple but may create cash-flow and collateral demands; a 75–80% hedge retains some flexibility while removing most currency risk. The 0.8% cost should be explicit in the funding plan, not hidden in the yield comparison.
Implement with layered forward contracts, for example rolling 3–12 month hedges with several counterparties, and set collateral and credit limits. Rebalance when the hedge ratio drifts outside a band, such as ±10 percentage points. Monitor basis risk, forward points, and liquidity. Do not hedge tactically on a view about sterling unless the policy permits it. Document why the charity accepts the yield give-up: it is buying reduced volatility and better matching of a sterling liability.