Friday, November 10, 2006

Currency Exposure and Hedging: Part I

Most investors don't think about currency exposure and leave their portfolio in the currency of their home country. When they invest in foreign assets they may consider their currency exposure and either try to take advantage of changes in the value of the foreign currency relative to their own currency or hedge it away. For small investors this usually means buying a fund that hedges the foreign currency exposure back into the domestic currency. But currency exposure is a choice even if it is a default choice. If you don't do anything about it you do not have a neutral exposure but probably a big exposure to your home currency. Now, if you are for example a US investor it may make sense to have a portfolio denominated in US Dollars as when you get to actually spend some of the money you will be spending in US Dollars if you are still living in the United States. Diversifying runs the risk that if the US Dollar gains value against foreign currencies over time your portfolio will lose value in US Dollar terms. But if the US Dollar loses relative value over time diversifying would result in gains.

For an international investor like myself with 75% of my net worth in Australian accounts and 25% in US accounts, who isn't sure what country he or she will be living in in the future, currency strategy becomes much more important. From a low in 2001 of less than 50 U.S. Cents the Aussie rose to around 80 cents in 2004-5 and is now trading around 77 U.S. Cents. As most of my assets were still in Australia when I moved to the US in 2002 I gained tremendously from the rise in the Australian currency. Since moving to the US I have sent considerable savings back to Australia when the AUD was at a level that I perceived as attractive.

I don't know if the Aussie Dollar will keep rising. It is no longer undervalued like it was at the beginning of the decade and 80 U.S. Cents has provided resistance during the last decade. On the other hand, I don't see any compelling reasons to cause it to fall. So now we are in more of a trading environment.

As my net worth has grown the absolute dollar value of changes in the exchange rate have of course increased. My Australian Dollar exposure is $A341k. Therefore, a 1 cent move up or down in the Aussie changes my net worth in USD terms by $US3410. That's very nice when the Aussie is rising but not good news when it is falling. The changes in my net worth measured in Australian Dollars are much less of course.

I'll discuss different hedging strategies in upcoming posts.

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