Currency Hedging with Asymmetric Carry and Correlation
A UK multi-asset fund with £1.5bn of assets holds 45% in overseas equities: 20% US, 12% euro area, 8% Japan and 5% emerging markets. Currency exposure is currently unhedged. The investment committee is reviewing a proposal to hedge 50% of developed-market currency exposure using rolling one-month forwards. Short rates are 5.25% in the US, 3.50% in the euro area and 0.10% in Japan, against 4.00% in the UK, so hedging the dollar leg costs about 1.25% a year, hedging the euro leg costs about 0.5%, and hedging the yen leg earns about 3.9%. Annualised currency volatility is 10% for USD/GBP, 7% for EUR/GBP and 12% for JPY/GBP. Historically the yen has been negatively correlated with global equities in risk-off episodes, while the dollar has been positively correlated. The fund's liabilities are sterling and its objective is to beat a sterling-based composite benchmark.
1. Evaluate whether the fund should hedge its currency exposure and how the appropriate hedge ratio should differ by currency.
Read the worked answer
The decision should be driven by the correlation of each currency with the fund's risk assets and liabilities, not by the carry alone. For a sterling-liability fund, hedging a currency normally reduces the volatility of returns measured in the liability currency, but the size of the benefit differs sharply by currency.
- USD (20% of the fund). The dollar is positively correlated with global equities in risk-off episodes, so unhedged dollar exposure amplifies drawdowns in sterling terms. Hedging reduces volatility. The 1.25% forward cost is the interest differential, not a pure fee; under covered interest parity it is the expected cost of hedging, but the risk reduction is worth paying for.
- EUR (12% of the fund). Lower volatility of 7% and a smaller differential of 0.5% make hedging cheaper and modestly risk-reducing. Volatility reduction per unit of carry is attractive.
- JPY (8% of the fund). This is the highest-volatility currency at 12%, and hedging earns 3.9% carry, which is attractive. But the yen is negatively correlated with equities in risk-off episodes, so unhedged yen is a natural hedge: in an equity sell-off the yen typically appreciates, offsetting losses. Hedging the yen converts a diversifier into a carry trade and increases the portfolio's correlation to equities.
So a uniform 50% ratio is not appropriate. A risk-based approach would hedge USD and EUR at 50-75% and JPY at 0-25%.
2. Recommend an implementation approach and identify the main risks in the proposal.
Read the worked answer
Recommendation:
- Hedge ratios. 60-75% for USD, 50% for EUR, 0-25% for JPY, and 0% for emerging markets on grounds of cost, non-deliverability and correlation with commodities. Overall this is roughly 50% of developed-market exposure, consistent with the committee's headline proposal but with a very different composition.
- Implementation. Rolling forwards are appropriate for USD and EUR because the hedge is structural and the cost is the rate differential; use three-month rather than one-month forwards to reduce roll and operational risk. For the residual yen exposure, consider a dynamic overlay that increases the hedge when the carry is unusually high and reduces it when risk appetite deteriorates, or a put option on JPY/GBP if the committee wants protection against yen weakness without giving up the safe-haven property.
- Benchmark and governance. Set a hedged benchmark, for example 50% hedged, so the currency decision is measured explicitly, and report carry earned or paid separately from currency return.
Risks to flag: forward hedges create counterparty exposure and margin calls; a 10% broad appreciation of sterling on a 50%-hedged book costs roughly 2.25% of the fund; the negative correlation of the yen is not guaranteed and has failed in episodes when Japanese rates were pinned and energy import costs drove the currency, such as 2022; and the carry argument for hedging the yen disappears if Japanese rates rise. Review the policy if rate differentials narrow materially.