For a long time I’ve thought that currency hedging for foreign investments isn’t necessary. The logic is pretty simple – if you’re buying a real asset (such as a company or real estate) the price should be comparable across countries as long as the value is the same. In other words, the market for currencies should be efficient or someone will drive it back to a balanced point and make a profit. Based on this view it doesn’t make sense to pay extra to avoid an effect that will cancel itself out (if a currency declines, the price of real assets in that currency should rise). However, I have come across an interesting new twist to this.

I recently read The Return of Depression Economics by Paul Krugman. One of the points he makes it that exchange rates are strongly influenced by governments and speculators (I’m now reading Panic, edited by Micheal Lewis, which covers some of the same ground). Governments have a variety of ways to control the exchange rate from setting interest rates (in stable economies that can use less direct control) to various restrictions and counter-balancing actions (in less stable economies). Although they usually have an effect on the exchange rate over the long term, speculators can make short-term moves that overpower any government attempts to control the exchange rate. Sometimes these are well-reasoned, and other times they’re self-fullfulling prophecies. Speculative moves usually don’t have the same long-term impact as government policy so for the most part they are just noise.

Governments are sometimes caught in a conflict between supporting their economy and supporting their currency, which  leads to situations where currency hedging may be desirable. Since the needs of each economy at any time are different, they may take actions which go against the long-run trend of the currency and investors may join in to support this move; in fact sometimes it is mostly caused by changes in the pattern of investments rather than official policy. In the last year the value of the US dollar has held up well because of the view that it’s safe, despite the fact that the country’s financial situation seems to point in the opposite direction in the long run (in this case it’s not even a government action as interest rates were cut during that time).

In the end it depends on the focus of governments. If they try to support their local economies and forget about the exchange rate, then local businesses should do better in the local currency and hedging would lead to a gain. If they try to support the exchange rate at the expense of the local economy then hedging will cause a loss. Of course, over long enough periods of time such an easy way to make money will face pressure from speculators who try to extract all the value until the markets return to balance (or, more commonly, overshoot). Another problem is that policies can shift rapidly, so a decision to hedge or not to hedge must be revisited regularly.

Ultimately both sides of the argument carry a possibility of a profit or a loss and there is no clear answer. There may be times when governments and investment patterns support a currency that’s out of balance; in this case a well-informed investor could take advantage to protect investments or profit directly from it. On the whole this has to be a losing strategy after fees, but with enough information it is possible to come out ahead.

Beginning investors don’t need to concern themselves with this as much; as long as the effects are for currencies to be priced too high sometimes and too low sometimes, any moves made over a period of times (such as monthly investments for 30 years) will face a much smaller impact from mispriced currencies. For my part I don’t know enough to make judgements on exchange rates, although with a large part of my income coming from outside the country it would make sense to consider investments strategies that have a negative correlation with moves that would reduce my income.

This is just another example of how markets aren’t always efficient, because competing short-term needs might dictate policies and actions that go against the equilibrium. The biggest way to avoid volatility is to make regular investments over time – if the prices are too high sometimes and too low sometimes then the average could be just what you want, with no extra expenses. With enough knowledge of the global economy (and the local economies and governments in all the countries involved, as well as the investors in the market) it’s possible that currency hedging for foreign investments has some value. What do you think – are there clear signals to protect yourself, should you always hedge your investments, or do you just take what the market gives you?