Exchange Rate Impact on Investments — Hedged vs Unhedged

Exchange Rates and Investments: Unhedged vs Hedged, Carry, and Break-Even FX

When you invest abroad, your total result depends on two moving parts: the asset’s local return and the currency move. If you measure performance in your home currency and define the exchange rate S as “home per 1 unit of foreign,” the unhedged home-currency return over a period is:

(1 + R_home) = (1 + R_local) × (S₁ / S₀)

Put simply, a rising S (your home currency weakens) boosts home returns, while a falling S drags them down. This FX leg can diversify, dampen, or amplify the local market’s ups and downs depending on the correlation between currency moves and asset returns.

What does “hedged” mean?

A currency-hedged approach uses a forward contract (or similar) to lock in a conversion rate for the period. The FX leg becomes the known forward/spot ratio, sometimes called carry:

R_hedged ≈ R_local + (F / S₀ − 1) − fees

Under covered interest rate parity, the forward reflects interest rate differentials between the two currencies. That differential shows up as a steady headwind or tailwind (carry). Hedging reduces FX uncertainty, but it is not “free”: you should account for forward points, spreads, roll costs, and any fund/overlay fees.

Break-even FX: “What move would hit my target?”

If you have a home-currency return target, the break-even FX ratio answers how much the exchange rate could move before you miss the goal:

S₁ / S₀ = (1 + R_target) / (1 + R_local)

This is handy for risk planning (“How much room do we have if the currency whipsaws?”) or for comparing hedged and unhedged policies side by side.

When to hedge vs stay unhedged

• Short horizons / low risk tolerance: Hedging can stabilize results and reduce tracking error to a home benchmark.
• Long horizons / valuation views: Unhedged exposure may add diversification or benefit from mean-reverting FX, but expect higher variability.
• Income mandates: If cash flows are in home currency, hedging can align assets with liabilities.
• Rate differentials: Positive carry can favor hedging; negative carry can make hedging costly.

Practical tips

• Be consistent with FX direction: Use “home per 1 foreign” throughout to avoid sign mistakes.
• Match tenors: Compare hedged vs unhedged over the same period; rolling hedges introduce roll dates and costs.
• Look beyond averages: The interaction term (local × FX) matters when moves are large.
• All-in costs: Include forward points, bid-ask, custody, and overlay fees when evaluating hedged results.

Bottom line: currency can be a quiet helper or a noisy spoiler. Understanding the split between local returns, FX moves, and carry helps you choose a policy that fits your goals—whether that is lower volatility via hedging, potential diversification from leaving FX unhedged, or a mix that adapts over time.