Multi-Currency Portfolios and Hedging Policy (CFA Level 1): Complexity of Multi-Currency Portfolios, Hedging Objectives and Policy Development, and Permissible Instruments and Hedge Ratios. Key definitions, formulas, and exam tips.
Investing across multiple currencies can feel exciting—kind of like bringing home souvenirs from every country you visit. But if you’ve ever traveled abroad and checked your credit card bill later, you likely realized that currency fluctuations can drastically change how much (or how little) you end up paying. Now imagine scaling that currency risk to a large investment portfolio. Even small exchange rate moves can have big impacts. This is where having a thoughtful multi-currency hedging policy really comes in handy.
A multi-currency portfolio holds assets denominated in more than one currency—like owning US equities, European bonds, and Japanese real estate investment trusts (REITs). Each asset has its own local currency exposure, which sits on top of the underlying asset returns. That currency overlay can either amplify your gains, reduce them, or even transform them into losses.
Currencies have their own volatility patterns, correlations, and interest rate differentials. Sometimes, large price movements seem to cluster (volatility clustering), making risk management that much trickier. On the flip side, exchange rates can offer some diversification benefits because not all currencies move the same way at the same time. In short, multi-currency investing can improve your return potential—but it can also create additional, sometimes unexpected, layers of risk.
A formal hedging policy is like a roadmap for managing foreign exchange (FX) risk. It is developed with three main objectives in mind:
The key is to figure out your goals and risk tolerance first. Then the policy codifies things like:
In practice, there can be a range of approaches—from fully hedged to partially hedged or even selectively unhedged strategies. The more specific and transparent the policy, the fewer surprises you’ll have down the line. You really want to avoid the scenario where currency fluctuations chip away at carefully constructed portfolio returns simply because there was no plan in place.
Permissible instruments form the toolbox for hedging. Commonly used are:
Once you know which tools you can use, you need to determine how much of your foreign currency exposure to hedge. Some investors prefer a 100% hedge in low-volatility asset classes like bonds, especially if they want stable income in their home currency. Others may hedge only partially to keep some upside potential if the foreign currencies appreciate.
Sometimes you’ll see a sliding scale. For example, an investor may hedge up to 50% of equity currency exposures but fully hedge bond exposures. This approach acknowledges that equity returns can be larger relative to currency moves, and partially hedging might provide a decent risk–return trade-off.
A rebalancing threshold imposes discipline. Imagine your original hedge ratio is 80%, but currency fluctuations cause your exposure to drift. If that ratio falls to 70% or rises to 90%, the policy might trigger a rebalance to restore the initial target or an allowable band (e.g., 75–85%). This ensures that the portfolio doesn’t become unintentionally over- or underhedged.
Decision-making responsibilities should be spelled out:
A clearly defined workflow avoids confusion and ensures prompt action when thresholds are breached.
Bonds are particularly sensitive to currency volatility because many bond investors focus on stable income (coupons) or preservation of capital. Using cross-currency swaps, a portfolio manager can exchange the coupon and principal payments denominated in a foreign currency for flows in the base currency.
Let’s say your base currency is USD, but you hold a Japanese government bond that pays coupons in JPY. You might enter into a cross-currency swap that effectively “converts” those JPY interest payments into USD at a pre-agreed exchange rate schedule. This helps secure stable, predictable cash flows. It’s worth noting that cross-currency swaps can have complexities involving interest rate differentials. If the interest rates between the two currencies differ significantly, it can change both the cost and the net returns of implementing the swap.
Equities generally have greater price volatility than bonds, so some investors are more comfortable leaving at least part of the currency exposure unhedged. Alternatively, you can aggregate multiple equity exposures into a single net currency position and perform “aggregated hedging.” If your portfolio is diversified across several currencies, you might net out offsetting exposures first, then hedge only the remainder. This reduces the number of trades.
For instance, if your portfolio is 50% invested in EUR and 30% in GBP, and you’re comfortable with a 60% total equity hedge, there might be a combined strategy to hedge each currency individually or hedge the net exposures with fewer, larger trades. This aggregated approach often lowers transaction costs and operational complexity.
Emerging and frontier markets pose extra challenges due to higher FX volatility, lower liquidity, and higher transaction costs. Full hedging might be too expensive or operationally impractical, so some investors adopt partial hedges or leave certain exposures completely unhedged:
Additionally, non-deliverable forwards (NDFs) can be used where currency controls restrict the use of standard forwards.
Tax laws can complicate currency hedging. In some jurisdictions, gains on derivatives (like forwards) might face withholding taxes, or gains could be treated differently from capital gains on the underlying asset. This can dampen (or, in rarer cases, enhance) the effectiveness of the hedge. Policies also need to address:
Skimping on the legal/tax side can create nasty surprises at year-end, so it’s crucial to define how hedging strategies will be monitored and accounted for over time.
Global markets shift. Interest rates, monetary policies, and currency correlations don’t stay the same forever. One day, a currency might be stable; the next day, it might be subject to unexpected central bank interventions or capital flow restrictions. That means successful hedging policies aren’t set-and-forget. They require periodic reviews and updates:
The hedging policy should be flexible enough to adapt but stable enough to avoid constant revisions. I once worked with a client who updated their policy so frequently that the real risk was the whiplash from tracking the changes. Having a well-documented framework and predetermined intervals for policy review can keep you on track.
Imagine you’re the Chief Investment Officer (CIO) of a pension fund with a base currency of USD and a global allocation that includes EUR- and JPY-denominated bonds, along with a broad equity allocation spanning the US, UK, European, and Asian markets. After some deliberation, you decide on:
graph LR
A["Investor's <br/>Base Currency"] --> B["Foreign <br/>Currency Exposure 1"]
A["Investor's <br/>Base Currency"] --> C["Foreign <br/>Currency Exposure 2"]
B["Foreign <br/>Currency Exposure 1"] --> D["Hedging <br/>Instruments"]
C["Foreign <br/>Currency Exposure 2"] --> D["Hedging <br/>Instruments"]
In this simple diagram, the investor’s base currency remains the reference point. Each foreign currency exposure can either be hedged with instruments like forwards, futures, swaps, or left partially unhedged based on the policy. This aggregated view can streamline the process.
Multi-currency portfolios require a structured but flexible policy. A robust hedging framework clarifies which instruments to use, how much of each exposure to hedge, how often to rebalance, and who is responsible for each part of the process. It also ensures key considerations—like taxes, liquidity, and frontier market constraints—are addressed.
From a practical exam standpoint, be prepared to:
Remember that a sound hedging policy aims to reduce unrewarded currency risks without crippling the potential for returns. You want to keep your portfolio on track for its original objectives, instead of getting derailed by shifts in exchange rates and associated transaction costs.
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