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Mitigating currency risk in global equity benchmarks

As currencies around the globe continue to fluctuate, investors have grown increasingly aware of the impact of currency movements on international investments. Currency risk concerns are justifiably widespread – investors benchmarking to the most widely used international indices can own securities denominated in numerous currencies, thereby exposing them to currency risk.  

Currency hedging can be an effective approach to mitigating currency risk, such that an investor holding foreign securities can be protected from exchange rate changes. One of the more common currency hedging strategies is purchasing forward contracts, which is an agreement to buy or sell a currency at a fixed price on a later date. This enables investors to lock in an exchange rate, thereby insulating them from rate fluctuations.

Pursuant to this currency hedging strategy, FTSE uses spot and forward contract rates to calculate currency hedged indexes. This methodology allows exposure to the returns of the foreign assets in the index without exposing the index to the volatility of exchange rates.

Whether a US investor would benefit from currency hedging is dependent on how the US dollar moves relative to the currency in which the foreign investment is denominated. If the US dollar is appreciating, the investor would be holding assets in a depreciating foreign currency and therefore a US dollar hedged strategy would be advantageous. Conversely, if the US dollar is depreciating relative to the foreign currency, the investor would benefit from holding securities in a strengthening foreign currency. In this case, a US dollar hedged strategy would underperform an unhedged strategy.

This dynamic is evident when examining the FTSE Developed Europe ex UK Index relative to the FTSE Developed Europe Ex UK Hedged USD Index in different currency environments. As the index is comprised of over two-thirds euro-denominated securities, the performance of the US dollar relative to the euro significantly impacted index returns. As demonstrated below, the US dollar depreciated relative to the euro in 2013, and as a result the unhedged index delivered stronger performance. The opposite is true for 2014, when an appreciating dollar versus euro led to higher returns for the hedged index.

 

 Source: FTSE as of December 31, 2014. The “Hedged Index” refers to the FTSE Developed Europe Ex UK Hedged USD Index. The “Unhedged Index” refers to the FTSE Developed Europe ex UK Index. Past performance is no guarantee of future results.

The above data demonstrates that it is important for investors to recognize there are two considerations when determining whether a currency hedging strategy could be advantageous. It is imperative to evaluate both the currency exposure of their investments and the broader currency environment.

 

 

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Neither the London Stock Exchange Group companies nor any of their licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the FTSE Russell Indexes or the fitness or suitability of the FTSE Russell Indexes for any particular purpose to which they might be put.

The London Stock Exchange Group companies do not provide investment advice and nothing in this communication should be taken as constituting financial or investment advice. The London Stock Exchange Group companies make no representation regarding the advisability of investing in any asset. A decision to invest in any such asset should not be made in reliance on any information herein. Indexes cannot be invested in directly. Inclusion of an asset in an index is not a recommendation to buy, sell or hold that asset. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

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Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back-tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.

 

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