Investing internationally introduces an extra layer of risk to any portfolio: namely currency risk. But what are the basic principles of currency management, and why is it so important?

A foreign currency?s performance can significantly affect the return on your portfolio. Look at Wall Street as an example: the S&P 500 index has climbed over 20 percent from the start of 2006 to date, in dollar terms. If, however, you were a euro investor, your return would have been diluted to just six percent due to the weakness of the dollar versus the euro.

It?s even worse in sterling terms ? with the British currency one of the strongest global currencies over the last few years, it in turn meant the S&P 500 index gained a mere 3.5 percent in pound terms.

Two risk layers

This shows there are two layers of risk in any foreign investment: the underlying asset holding and the equivalent amount of foreign currency.

The foreign currency exposure can be managed using currency forward contracts, which effectively convert unhedged returns into hedged returns, thereby removing part or all of any currency risk. Currency hedging will enable a fund manager to invest in additional return-enhancing asset classes within a portfolio without taking on unwanted foreign currency risk, thus reducing the overall volatility of the fund.

To this end, it could be argued that active currency management may be deemed as one of the most important risk control measures for any internationally invested portfolio.

What goes for what?

• Spot rates in the foreign exchange market are for immediate delivery and the standard settlement timeframe is two days from the date of trade execution.

• A foreign exchange forward or futures contract is an agreement to deliver the currency at some point in the future and therefore the trade date and delivery date are separated.

Setting the appropriate level of hedging also depends on how much currency risk the fund wishes to adopt and this may be influenced by the liabilities, risk tolerance and foreign currency restrictions etc. For example, if a sterling-based portfolio owns $50-million worth of US equities and the fund manager has a view that the dollar will weaken versus sterling, the manager may then sell $50-million versus sterling for delivery at some date in the future.

If the dollar does fall, the profit on the hedge will offset the currency loss on the US equities position. By the same token, if the dollar strengthens, the loss on the hedge will offset the currency profit on the US equities position. In other words, the currency hedge described here removes all of the portfolio's exposure to the dollar.

Why do some avoid it?

Most mutual funds generally do not participate in currency hedging for two reason: firstly, many international equities are (in theory) self-hedging. How does this work? Well, any currency movements (adverse or beneficial) for a particular company will be discounted in its share price via the stock market.

Secondly, the performance of the average mutual fund is usually measured relative to an appropriate benchmark in a particular currency and, hence, a tracking error risk would be introduced if currency hedging were to be adopted.

However, for absolute return managers it is vital to control currency risk, as it would be futile after achieving respectable returns from investing internationally, only to have a large amount or all of your gains diminished from adverse currency movements as indicated in the example at the start of this article. Therefore, it makes sense that if currency hedging were to be adopted and managed efficiently, this could not only enhance the returns of a globally invested portfolio but also reduce the risk.

Reduce volatility

It is clear that active currency management has an important role in investment management. Most conventional funds take the decision not to hedge and are content to run with any adverse or beneficial currency movements.

Yet through judicious use of currency hedging, a fund may have its returns bolstered and volatility reduced, thereby enabling the fund manager to have the best of both worlds.