The emphasis on risk reduction within a passive currency management style deals with the basic idea that the portfolio’s return in the base currency is equal to:
The return of foreign assets invested in + the return of the foreign currency
This is a simple, but hopefully effective way of expressing the view that there are two separate and distinct risks present within the decision to invest outside of the base currency. The motive of risk reduction is therefore to hedge to whatever extent decided upon the return of the foreign currency. From this basic premise, we can extrapolate the following:
Return (unhedged) = Return (asset) + Return (currency)
and
Return (hedged) = Return (asset) + Return (hedge currency)
The overall aim remains the same, and that is to reduce the overall risk of the portfolio, maximizing the total or absolute return in the process. In other words, it is to boost the portfolio’s Sharpe ratio, which is usually defined as the (annual) excess return as a proportion of the (annual) standard deviation or risk involved.
It should be noted from this formula however that some investors balk at the idea of hedging on the simplistic view that the hedge cost automatically reduces not just the hedged return of the asset but the asset’s total return in base currency terms. This is not necessarily the case. Actually, the converse can be argued, namely that the hedge reduces or eliminates any possible currency loss. Whether or not the investor hedges, there is the foreign currency return to be considered. That may add or detract from the asset return in foreign currency terms, and therefore may in turn boost or reduce the asset return in domestic currency terms. The hedging cost component will clearly depend on a number of variables, including the currency hedging benchmark and the financial instruments that can be used, but has clear parameters. The potential unhedged currency loss is theoretically limitless.