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In an era of shifting economic power and heightened market volatility, global investors face unprecedented currency risks. While the historic outperformance of US equities has driven portfolio returns, it has also introduced substantial exposure to the US dollar. Without effective mitigation strategies, these exposures can drastically alter outcomes when exchange rates move against investors. This article explores why currency hedging has escalated from a tactical option to an essential component of diversified portfolios.
Over the last decade, the rally in US equities has led many global portfolios to accumulate a significant overweighting to US assets. As of April 2025, US equities represent over 60% of the FTSE All-World benchmark, leaving non-US investors inadvertently leaning into dollar risk. When the dollar strengthens or weakens, it can overshadow underlying asset performance, turning profits into losses or vice versa.
For example, a euro-based investor in a classic 60/40 equity-bond mix experienced a local currency loss exceeding 10% through April 2025. Hedging currency risk would have cut that loss in half. The contrast highlights the dramatic difference made by hedging during periods of currency volatility, underscoring its strategic relevance.
The foreign exchange (FX) market is world's largest, trading $805 billion per day, facilitating every cross-border transaction and investment. Currencies always trade in pairs, establishing relative values that drive returns for global portfolios. Understanding this market’s scale and mechanics is foundational for any hedging strategy.
Hedge ratios measure the proportion of currency exposure that investors choose to mitigate. For instance, holding JPY100 of assets with a short JPY-50 FX forward equates to a 50% hedge ratio. These ratios can shift rapidly, prompting large, immediate flows in FX markets as investors rebalance to target levels.
Strategic hedging offers investors the ability to reduce portfolio volatility and downside risk, especially when the outlook for the US dollar is negative due to widening deficits or slowing growth. By selectively mitigating currency swings, portfolios can focus on underlying asset performance rather than exchange rate noise.
Beyond strategy, hedging introduces accounting and regulatory complexity. Under US GAAP and IFRS, firms must follow complex procedures for recording and reporting foreign currency transactions, treating transactional, translational, and economic exposures differently. These distinctions influence hedge design and effectiveness.
Investors employ a variety of instruments to manage currency risk, choosing based on cost, liquidity, and risk appetite.
Many institutions implement overlay strategies, adding a layer of currency hedges on top of underlying asset positions rather than altering those holdings directly. Dynamic hedging adjustments occur as currencies strengthen or weaken, or as policy shifts reshape economic outlooks. Not all investors hedge equally: European firms tend to hedge more than Asian or US counterparts, reflecting local policy and return considerations.
As of mid-2025, many forecasts point toward a 15%+ multi-year decline in the US dollar driven by fiscal deficits, current account imbalances, and political uncertainty. Although episodes of dollar strength may arise during global crises, the prevailing trend is weaker, amplifying unhedged exposures for non-US investors.
Accelerated FX hedging by non-US investors implies large-scale USD selling purely for currency risk management. Beneficiaries may include the euro, yen, and other major currencies viewed as stable alternatives. Investors must weigh these macro trends when setting hedge ratios, balancing cost against potential currency moves.
In a multipolar world where currency moves can eclipse asset returns, hedging has shifted from an occasional safeguard to a core, ongoing portfolio management strategy. Data-driven insights, robust tools, and disciplined execution are critical for navigating the FX landscape. By embracing well-designed hedging approaches, global investors can secure more predictable outcomes, align performance with strategic objectives, and confidently pursue opportunities across borders.
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